British inflation is now at a 30-year high after another surge in goods inflation pushed January’s rate to 5.5%. Inflation hasn’t been this far above the Bank of England’s 2% target since the target was introduced in 1992.
Now that an interest rate hike seems a certainty in March, the question now is whether the hike will be 0.25% or 0.5%. We think 0.25% would be most appropriate, but 0.5% can’t be ruled out. We’re expecting another 0.25% rise in May, and for the committee to hit pause after May as the inflation outlook becomes more benign in the second half of the year. That means we expect interest rates to be closer to 1.0% by the end of the year than to the 2% the financial markets expect.
Goods prices still rising…
Goods prices were again the main reason behind the acceleration. Price rises continue to reflect the global imbalance between supply and demand, which has seen costs soar. This meant that this year’s January sales were less generous than usual.
Clothing inflation rose from 4.2% to 6.3% as retailers reduced prices this January by less than they did in the same period last year. There was a similar story behind the rise in furniture and furnishings inflation from 11.2% to 12.5%. Rising rents also added some upward pressure. This is an area worth watching, as rocketing house prices may seep through into CPI.
…But services prices took a dip
The rises in goods prices were offset by large drops in inflation in restaurants, hotels (from 6.0% to 4.7%) and transport (from 11.9% to 11.3%) as omicron blunted demand.
Overall, the inflation story is still dominated by energy prices and the prices of a select number of goods, which were heavily affected by the pandemic. In contrast, inflation across the services sector, which makes up the bulk of the economy and is a better measure of domestically generated inflation, only ticked up last month.
Goods inflation jumped from 6.9% in December to 7.2% in January, while services inflation actually fell from 3.4% to 3.2%. Meanwhile core inflation, which excludes, energy, food, alcohol and tobacco, rose from 4.2% to 4.4%.
A large part of the dip in services inflation in January was probably due to omicron so may rebound as those sectors reopen. But the MPC may take a little bit of comfort from lower services inflation, because it suggests that prices in the bulk of the economy aren’t following goods prices up the inflation mountain.
In our baseline forecast, inflation drifts higher in both February and March to a little below 6%. It is then expected to jump to around over 7.5% in April – when the 54% spike in the energy price cap takes effect. Beyond that, annual CPI should fall back to around 5% by the end of the year, driven almost entirely by an easing in goods inflation. That judgment reflects the view that both a moderation in global demand and a loosening of supply pressure will ease the pressure on goods prices.
Assuming that energy prices continue to ease, we expect a significant further softening in 2023. If energy prices rise again, perhaps due to Russia invading Ukraine, then we could easily see inflation top 8% in Q2 and remain above 5% in 2023.
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.
The committee is particularly concerned that the shock to prices from soaring energy prices, which will probably push inflation to a peak of a little over 7% in April, will cause inflation expectations to become unanchored, leading to higher inflation in the medium term.
The combination of stronger-than-expected GDP data, rising wage gains and continually rising inflation is likely to mean the Bank considers a larger-than-usual rate hike in March. The four policy makers who voted for a rise of 50 basis points (bps) this month have already signalled a willingness to move in bigger steps. However, we think the majority will continue to favour increments of 25bps.
That’s largely because the MPC was pretty clear at its last meeting that it thought the degree of tightening markets had priced in was too much, and a 0.5% rise in March was likely to cause the market to price in even more tightening!