March 9, 2023
Recent news on inflation has been mostly positive in the UK. In January, the Consumer Price Index (CPI) showed that annual price increases slowed for a third consecutive month to reach 10.1%, down from a near-term high of 11.1% last October. However, forecasts that inflation will now quickly fall back to the Bank of England’s 2% target are likely premature.
In the coming months, inflation is expected to fall faster than previously expected given the steep drop in wholesale natural gas prices witnessed since the start of the year. While the passthrough to consumer prices is lagged by several months, the disinflationary impact of this will be felt from July onwards and is expected to strengthen over the second half of the year. More precisely, based on current forecasts the Ofgem energy price cap is expected to fall to around £2,153 in July, which is around 9% higher than at the same time last year, before rising slightly to £2,161 in October, which is 14% below where the price cap stood in autumn 2022. For reference, the price cap valid for Q1 this year was nearly double that of 2022 while the Q2 price cap is still more than 50% up compared to a year ago.
While there is of course always a risk of new shocks in the global energy markets emerging over the course of the year, these energy forecasts seem relatively certain and have hardly budged over the last few weeks. A further aspect to consider is that the CPI weights are recalculated every year by the Office for National Statistics (ONS), based on the representative consumption basket. We expect energy to be assigned a significantly higher weight from 2023 onwards, reflecting the larger outgoings by households on utility bills over the past year. This will amplify the disinflationary impacts from negative annual changes in energy prices in the second half of the year.
But while there is a reasonable consensus about the direction of travel for inflation over the coming years, we don’t share the conclusion reached by the Bank of England or other forecasters that inflation will come back down to the 2% target very quickly. Indeed, we don’t expect CPI inflation to fall below 4% by Q4 2023 for the following reasons.
First, the UK labour market is still relatively tight by historic norms despite the recent uptick in unemployment. Vacancies have come down only slowly from their record highs recorded last year and there is still nearly one vacancy available for every unemployed person in the UK. The Q4 2022 ratio of unemployed people per open vacancy stood at 1.1 – well below the long-run average of 3.
The tightness in the labour market is reflected in wage growth figures. While earnings growth figures still lag behind inflation, the lack of available workers in the economy increases workers’ bargaining power in the private sector. In the meantime, the wave of industrial action seen since last year is unlikely to abate until a satisfactory wage settlement for various public sector workers is found. Moreover, there is a risk that higher wage increases will start to be expected by workers going forward even as inflation subsides which could lead to the emergence of a wage-price spiral.
In more technical terms, all of this could mean that core inflation will be substantially more sticky, which would imply that there is a limit to the expected moderation in inflation even as prices for energy and food reverse course. This is what was seen in recent Eurozone data which showed core inflation rising to a record high of 6.3%. In the UK, January data showed an encouraging drop in core inflation to 5.8% down from 6.3% in the two preceding months, though even at this level, domestic price pressures run well above the Bank of England target.
Finally, a look at history also teaches us to be wary of any forecast that we will return to the pre-pandemic inflation regime anytime soon. In the 1970s, inflation started to level off after the first oil price shock but began to rise again even before the second oil price shock hit. The credibility of the commitment of the central bank is crucial here. If the Bank of England is overly complacent and loosens policy even if inflation fails to drop substantially below 4% or 5% later this year, businesses and consumers could take this as a sign that policymakers have given up at attempts to bring inflation down further. This could then become a self-fulfilling prophecy and cause inflation to remain at elevated rates for longer. The hope here is that central bankers have learned the lessons of the past. We expect a steady decline in inflation, though aren’t anticipating a fall back to 2% for a number of years. However, controlling prices will require a firm hand by the Bank of England, which should resist calls to cut rates at the first signs of success.
Source: Centre for Economics and Business Research (CEBR)
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