Still more inflation to come

The surprise strength in goods inflation pushed inflation in November to 5.1%, well above the Bank of England’s 4.5% forecast. Inflation should stay around current levels until April, when it will likely peak at about 5.5%. The economic uncertainty created by the omicron variant may be enough to prevent the Monetary Policy Committee (MPC) from hiking interest rates on Thursday, but high inflation and a tight labour market mean it’s unlikely to delay tightening for long.

Goods prices driving the inflation train 

There were five drivers behind the rise in inflation from 4.2% in October to 5.1% in November: 

  1. Motor fuel CPI inflation leapt to 28.5%, from 21.5% in October, in response to rising global oil prices and the recent weakness in Sterling. 
  2. Tobacco CPI inflation increased to 6.8%, from 2.4%, because duties rose again in late October. 
  3. Food CPI inflation rose to 2.5%, from 1.2% in October, as the recent pick-up in producer prices fed through into retail prices. 
  4. Second-hand car CPI inflation jumped to 27.1%, from 22.8%, due to a lack of new vehicles. 
  5. Clothing CPI inflation picked up to 3.5%, from -0.4% in October, as the pandemic changed the timing of sales.  

However, services inflation remains relatively subdued. Indeed, goods prices inflation rose from 4.9% in October to 6.5% in November, while services inflation ticked up from 3.3% to 3.4%. 

What next? 

Inflation will probably remain around 5% over the next few months as unfavourable base effects, higher oil prices and goods shortages continue to make themselves felt. It will probably peak at 5.5% in April – that’s when Ofgem increases its price cap again.

Futures markets suggest that energy prices should start to come down next year and base effects will fall out of the annual comparison. This means that inflation will fall just as quickly in the second half of 2022 as it has risen in the second half of this year. Inflation could actually fall below 2% in early 2023 if energy prices continue to drop. 

The policy takeaway 

Today’s data adds to the case for raising interest rates sooner rather than later. The labour market is tight, and inflation is set to remain at more than twice the Bank of England’s target for at least six months. The strength of recent inflation data means an interest rate rise from the Bank of England can’t be ruled out on Thursday. However, the weak GDP data for October and the uncertainty created by the omicron variant means the MPC will probably hold off on raising rates at its meeting tomorrow. 

Providing the risk to public health from omicron can be contained without causing a significant delay to the recovery, the odds are that in February the central bank will raise the key rate to 0.25% from 0.1%.

A second rate hike could then come as soon as May if the labour market continues to tighten over the winter. That said, rapidly falling inflation in the second half of 2022 should mean that the MPC does not need to lift rates by as much as financial markets anticipate. Realistically, we think that by the end of the year interest rates will be closer to 0.5% than to the 1% the financial markets have priced in.