A pause on the way to 5%

Inflation paused for breath in September, slipping to 3.1% from 3.2% in August, but this won’t last long. Surging energy prices and supply-chain disruptions will push inflation to a peak of close to 5.0% by April 2022, then it will fall just as quickly over the rest of 2022 as base effects fall out of the annual comparison. 

The Monetary Policy Committee (MPC) has become increasingly hawkish over the last few weeks, so rate hikes are clearly on the horizon – but slower economic growth over the rest of 2021 may give it some reason to delay tightening policy until 2022. 

The slight drop in the annual pace of inflation reflected two competing forces. Inflation continued to rise in most categories, especially food (0.3% in August vs 0.8% in September) and transport (7.8% vs 8.4%). The cumulative effect of lots of small rises was more than offset by a large drop in restaurant and cafe inflation (8.0% vs 4.1%) as prices for meals out returned to normal levels in September 2020 after the Eat Out to Help Out scheme cut prices for them in August 2020. This alone knocked about 0.3 percentage points off inflation in September.

Where next for inflation?

Inflation is set to jump to 3.8% in October as the recent spike in electricity and gas prices makes itself felt. It will continue to rise over the next month, and we think inflation will peak at almost 5% by April next year.

This means it will peak at a much higher level than the 4% the Bank thought it would do back in August, and it will remain high through the first half of next year. The persistence of above-target inflation has worried many MPC members that higher inflation will become permanent. Inflation expectations have been creeping up recently, and wage growth looks set to remain high into 2022 thanks to labour shortages.

The policy view

The MPC has become increasingly hawkish recently with Governor Bailey saying over the weekend that the MPC ‘will have to act’. As a result, financial markets are pricing in a 90% chance that the MPC will hike interest rates in November. Markets have a terrible history of overestimating how quickly interest rates will rise. Most MPC members will probably want to see how the end of the furlough scheme in September has impacted the labour market, and that won’t be known until the December meeting. If unemployment remains relatively steady in October then a rate hike in December is probable, but a raft of evidence that the economic recovery has stalled in the meantime may push the first rate hike back until early 2022.

This rise in inflation will weaken the outlook for activity over the rest of this year and into 2022 by reducing real incomes, and that will feed through into lower consumer spending in the real economy. And as base effects drop out of the annual rate next year and supply shortages ease, we think inflation will fall close to 2% by the end of next year. That’s why, no matter what date the MPC decides to raise rates, we doubt the Bank will raise interest rates very far.