Inflation surge far from over

British inflation is now at a 30-year high after the surprise strength of goods inflation pushed December’s rate to 5.4%. Inflation hasn’t been this far above the Bank of England’s 2% target since the target was introduced in 1992. 

Inflation should stay around current levels until April, when it will likely peak at about 6.5%. Higher interest rates will do little to dampen inflation that is being almost entirely driven by rising food, fuel and supply disruptions. The MPC, however, has a clear desire to shore up its inflation-fighting credentials and will want to act before inflation spikes in April. Every sign points to interest rates rising from 0.25% to 0.5% next month.

Goods prices still driving the inflation train 

There were four factors behind the rise in inflation from 5.1% in November to 5.4% in December: 

  1. Food CPI inflation leapt to a nine-year high of 4.5%, after registering 2.5% in November. The recent rises in global agricultural commodity prices suggest that food inflation will continue climbing over the next six months. 
  2. Restaurants and hotels inflation went up, from 5.2% to 6.0%, as a result of last year’s lockdown. 
  3. Furniture and household equipment jumped from 6.1% to 7.3% as strong demand generated by previous lockdowns and the snarl up in international shipping fed through into higher prices. 
  4. Clothing CPI inflation picked up to 4.2%, from 3.5% in November, as the pandemic changed the timing of sales. 

However, services inflation remains relatively subdued – goods prices inflation rose from 6.5% in November to 6.9% in December, while services inflation ticked up from 3.3% to 3.4%.

What next?

Inflation should hold at about 5.5% over the next few months as unfavourable base effects, higher oil prices and goods shortages continue to make themselves felt. The surge in energy prices means that we can expect Ofgem to raise the energy price cap by about 50%, which will push inflation to a peak of 6.5%.

The outlook for inflation over the next two years heavily depends on how energy prices evolve. Although inflation should start to drop in the second half of this year as base effects fall out of the annual comparison, a rate of around 4% by the end of 2022 seems likely.

The policy takeaway

Today’s data adds to the case for another rise in interest rates sooner rather than later. The labour market is tight, and inflation is set to remain at more than twice, and maybe three times, the Bank of England’s target for at least six months.

At its February meeting, the MPC will be forced to make a large upgrade to its inflation forecasts to reflect higher-than-expected energy prices. Given its desire to shore up its inflation-fighting credentials, there’s a clear argument for the central bank to act before inflation spikes in April. Every sign points to interest rates rising from 0.25% to 0.5% next month.

However, that will probably be the last move for a while and we expect the benchmark rate to end 2022 at 0.75%. That’s because slower wage growth, negative real incomes, and the possibility of inflation dropping below target in 2023 if energy prices fall are all reasons for the MPC to tread carefully before it lifts rates again.

 

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