How will inflation impact Bank of England interest rate decisions
The Bank of England faces a seriously tricky few months.
The first inflation figures of the year confirmed what many had already known: Inflation will rise significantly in 2025.
The headline rate of inflation jumped to 3.0 per cent, up from 2.5 per cent in December and ahead of the 2.8 per cent expected by many economists.
But this is only the beginning.
The energy price cap is expected to rise by more than six per cent in April, which will put upward pressure on the headline rate of inflation from spring.
Simon French, head of research at Panmure Liberum, warned that the path for inflation in the UK remained “highly contingent on gas prices and events in Ukraine”.
Combined with figures out yesterday, which showed surging wage growth in the final quarter of last year, and the inflationary outlook does not look good.
The Bank of England expects inflation to peak at 3.7 per cent in the third quarter of this year.
The good news
Despite January’s chunky increase in inflation, many analysts suggested that the figures would not push the Bank of England off from their gradualism on interest rates.
This is because it was largely driven by one-off factors or erratic movements. The most important single factor was airfares.
Airfares typically rise significantly in December, before falling in January. But December’s figures were unusually depressed, meaning the fall in airfares last month was much smaller than the previous year, which feeds through into higher inflation.
Another important factor was the introduction of VAT on private schools, which saw fees rise by around 13 per cent on the month, having not increased at all last year.
“The increase was driven by components that shouldn’t have too much of an effect on the MPC’s stance on monetary policy,” Ruth Gregory, deputy UK economist at Capital Economics said.
And while the headline rate beat expectations, services inflation – arguably a more important gauge of domestic price pressures – was lower than the Bank of England predicted.
It rose to 5.0 per cent from 4.4 per cent previously, falling short of the 5.2 per cent pencilled in by most City economists.
The fact that it did not match expectations suggests that domestic price pressures are not quite as severe as had been expected.
The Bank of England’s February forecasts suggest services inflation and wage growth will gradually ease in 2025, which is why Bank officials feel comfortable signalling further rate cuts this year even though the headline rate will rise.
“There is probably not enough in this report to materially move the dial on the near term outlook for policy,” Luke Bartholomew, deputy chief economist at abrdn, said.
Dangers
The Bank of England thinks that the increase in inflation will not spark wider knock-on effects in the economy. Speaking yesterday, Andrew Bailey, the Bank’s Governor, said the UK was facing a “short-run hump in inflation” driven largely by external factors.
But there is one domestic risk which could disrupt the projected path of disinflation: the Budget.
Business surveys suggest firms are planning to lift prices in response to the government’s national insurance hike to a greater extent than Bank officials expect.
Rob Wood, chief UK economist at Pantheon Macroeconomics, warned that a four per cent inflation reading later this year is “far from out of the question” given firms’ responses to the extra costs.
It remains unlikely that the Budget would spark significant second-round effects, but it could keep domestic prices a bit higher for a bit longer, which might force the Bank to adopt an even slower pace of interest rate cuts.
“While the surprise should not derail further gradual rate cuts, it will keep the BoE in the slow lane – especially as rising employment taxes, minimum wage increases and higher regulated energy prices add to cost pressures in 2025,” Kallum Pickering, chief economist at Peel Hunt said.