UK inflation falls, but what’s next for interest rates and the economy?

Inflation has finally retreated from double digits, coming in at 8.7% in the year to April. However, the growth in headline consumer prices was higher than expected and more than quadruple the Bank of England’s (BoE) target.

More worryingly, core inflation, which strips out volatile food and energy prices crept back upwards to 6.8%. It shows that the price spiral is still proving to be a stubborn beast to conquer for the BoE.

Why is inflation still so high?

Grocery prices are staying stubbornly high with food price inflation still running at 19.1% in April, only down fractionally since March. There had been expectations that lower wholesale food prices would feed through much more quickly. However, the power of big brands remains strong with companies able to pass on higher costs.

On the other hand, lower wholesale energy prices have finally started to feed through and should propel inflation lower in the second half of the year.

Read our latest energy shares sector review

Where next for inflation?

Although prices are on a downwards trajectory, it’s still unclear just how far and how fast inflation will fall. The BoE has already dialled back its expectations on how fast price rises will decline.

Although the Bank expect inflation to drop to 5.1% by the end of this year from 10.1% in March, it’s in contrast to the fall to 3.9% it predicted in February. The bugbear for the Bank is that food prices are expected to stay stubbornly high.

In fact, the BoE doesn’t expect inflation to hit the 2% target until late 2024. But the Bank is also admitting that the price spiral could prove harder to bring down than it previously expected. That’s why the road still seems wide open for at least another hike.

What could this mean for recession fears?

Rather than flagging and dropping back into recession, the economy is jogging very slowly onwards. The Bank has tweaked its forecast for underlying growth, estimating it to be around 0.2% for the first half of the year.

As consumers relax amid this better-than-expected health check on the economy, the latest data from the ONS indicates they’re ploughing through savings and racking up borrowing. Spending on debit and credit cards jumped 11 percentage points at the start of May.

This more optimistic attitude risks keeping the fires of inflation smouldering. Consumer goods giants have been able to pass on price hikes to consumers and with appetite to spend staying strong, that looks set to continue.

If prices stay elevated, the clamour for higher wages is also less likely to quieten, adding more fuel to the inflation fire.

Although the jobs market is loosening up a bit, with more of the inactive masses returning to work and vacancies falling, the numbers of long-term sick have risen again. It means the Bank of England’s worries about the fight for labour pushing up wages hasn’t eased off much.

Private sector pay grew 7% in January to March, but wages are still playing catch up with inflation and further pressure for more generous salaries is set to be applied. Policymakers worry that fatter pay packets will keep being passed on by companies in the form of higher prices.

Another rate rise might appear as a blow to the economy, which is only just seeing some green shoots appearing as the chance of recession recedes. However, policymakers don’t have many other strategies to deploy right now to try and guide inflation in the right direction.

Interest rates in 2023 - where will they go next?

This article isn’t personal advice. If you’re not sure whether something’s right for you, ask for financial advice.

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