A Deeper Look at Inflation: Are the Rate Rises Almost Over?

The UK economy seems to be turning a corner. In June, inflation fell more than expected to 7.9%, a 15-month low. In response, the Bank of England has opted for a less stringent interest rate rise of 0.25%. Andrew Bailey, the Bank’s Governor, suggested rates might almost be at their peak, while its chief economist stated, “monetary tightening… is working.” The Bank’s monetary medicine might have won it a small victory, but is disinflation likely to continue? This article will analyse recent inflation trends and assess the likelihood of further rate rises.

Inflation trends and outlook

The Consumer Price Index (CPI) rose sharply from 0.4% in February 2021 to 11.1% in October 2022, attributable to upward price movements of a range of goods and services, notably food, housing, clothing, alcohol, and transport. Since October 2022, inflation has been falling, albeit slower than in most other countries, to 7.9% as of June 2023.

Food prices

A key driver of CPI has been the surge in food prices, reaching a 45-year high in March. Supply of agricultural commodities has been severely impacted by Russia’s invasion of Ukraine, both of which are key producers of grain, wheat, and fertiliser. Ukraine's crop harvests and transportation hubs have been disrupted by the conflict. Russia – the largest exporter of synthetic fertiliser – has restricted exports and suffered its own supply disruptions. Rising energy costs, also primarily brought on by the Russian-Ukrainian conflict, have had a ubiquitous impact, notably on electricity and transportation. Red tape has been a further factor, as businesses grapple with supply chain changes following the end of the Brexit transition period. Some businesses blame the increase in red tape for shortages of fruit and vegetables imported from the EU.

The outlook for food prices is improving, falling month-on-month since March. A chief cause of this is disinflation upstream in the supply chain and the recovery of Western energy supplies, reducing key cost centres in transport and electricity. Due to the reduction in the price of motor fuels, the inflation rate of transportation is now negative. The annual inflation rate of food and non-alcoholic beverages was down from 18.4% in May to 17.4% in June. The chief executives of Tesco, Sainsbury’s, and Ocado have opined that food price inflation is past its peak. That said, the fall in food prices is unlikely to plummet sharply. Grain and fertiliser supply remains strangled, impacting supply chains upstream, and businesses will likely address squeezed margins before feeding cost reduction through to consumers.

Oil

Russia is one of the world’s largest producers and exporters of oil and gas. Following its invasion of Ukraine, oil prices exceeded $100 per barrel. Oil, like many other commodities, is priced in US dollars when traded on the world markets. If the value of the Sterling falls relative to the US dollar, it means that one pound can now buy fewer US dollars; and when the UK buys commodities priced in US dollars, such as oil, the cost in pounds increases. Sterling fell sharply against other currencies following Kwasi Kwarteng’s ‘mini-budget.’ Oil and other imports became more expensive temporarily, raising costs for businesses and causing them to offset this through raised prices, adding to the overall inflation rate. Following the reversal of the mini-budget, Sterling has recovered and is up 5.4% in 2023. Oil prices have fallen back to their early-2022 levels.

Gas

The Russian-Ukrainian conflict has also impacted the global gas supply. Sanctions, supply chain issues, and midstream pipeline sabotage sent wholesale gas prices to historical highs. This increase has fed through to households: the IMF claims that UK households have been hit the hardest in Europe due to its heavy reliance on gas. Gas generates heating for 85% of UK homes and 40% of its electricity. Between June 2022 and June 2023, domestic gas prices rose by 36% and electricity prices by 17%. This has cost UK energy providers an additional £50-60Bn, and UK households more than £1,000 on average. Consequently, the Consumer Price Index including owner-occupiers’ housing costs (CPIH) has risen significantly.

The outlook for wholesale gas prices has improved in 2023, having fallen month-on-month since January. Consumers and businesses have altered their energy usage, reducing the amount they use, in part due to rising prices and the warm winter. The European energy landscape has adapted quickly to the loss of Russian gas, expanding its liquefied natural gas (LNG) import infrastructure and increasing its reliance on non-conventional energy sources. Rishi Sunak, the other week, announced that hundreds of new licences to extract gas from the North Sea will be granted to secure the UK's energy security. Gas remains a volatile commodity, but its price, and therefore its proportion of CPIH, is trending down, which will reduce the overall inflation rate.

Monetary policy outlook

As highlighted, prices are steadily trending down, pushing inflation closer to the Bank of England’s 2% target. In its most recent interest rate decision, the Bank stated: “[CPI] is expected to fall significantly further, to around 5% by the end of the year, accounted for by lower energy, and to a lesser degree, food and core goods price inflation.” 

A notable outlier is services inflation, which sat at 7.2% in June, and “is projected to remain elevated at close to its current rate in the near term,” according to the Bank. This is only temporary: in the medium term, services inflation is likely to fall as businesses begin to experience the cooling of energy, fuel, and goods prices, freeing up their margins. The key challenge will be wage growth. Despite repeated warnings that people should expect to feel poorer as high prices persist, wages remain relatively high while unemployment is near record lows. When wages and employment increase, consumer demand also increases, reflecting more money in people’s pockets; this pushes up prices, keeping inflation up.

The Monetary Policy Committee stated in its rate announcement that it would ensure rates are “sufficiently restrictive for sufficiently long,” leading some to believe that interest rates are nearing their highest point and are likely to remain at this level for an extended period. 

By

Joshua Troup