When will UK inflation fall back to the BoE’s target?

The latest figures suggest UK inflation is starting to moderate, but investors shouldn’t celebrate just yet. Indeed, while the figures showed that CPI inflation slowed to 10.5% in December, from 10.7% in November, core inflation remains a severe problem.

The core inflation challenge

Inflation has spiked over the past year mainly due to higher energy prices, which have filtered through to every part of the global economy.

And while energy prices are now starting to come down (lower petrol prices were the main factor behind lower inflation in December), CPI is still miles away from the Bank of England’s (BoE) target inflation rate of 2% - a level not seen for over a year and a half.

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It could be harder to get inflation down to this level as higher prices become more ingrained in the economy.

Core inflation measures inflation excluding energy and food prices - the volatile components of the CPI measure. It’s designed to show the underlying inflation trends in the economy.

The Office for National Statistics (ONS) calls core inflation the more “durable” part of inflation because it tends to stick around longer than say shocks from energy prices.

Now, at 6.3% core inflation isn’t anywhere nearly as high as headline inflation. But - and here’s the problem - it has remained unchanged since November, staying firmly above 6% for the past six months.

Experts believe that this could be crucial in the BoE’s interest rate decisions.

Tommaso Aquilante, Associate Director of Economic Research at Dun & Bradstreet says “It is possible that a continued persistence of core inflation could result in the central bank continuing with aggressive tightening in order to bring price pressures down.”

Adding to this, Colleen McHugh, Chief Investment Officer at Wealthify says, “Core inflation is broken down between ‘core goods’ and ‘core services. From the BoE’s perspective, the key component of the inflation data to watch is the core services measure.” It has almost doubled over the past year, coming in at nearly 7% in December.

Will UK inflation follow US inflation lower?

Across the pond, there are some signs that policymakers are starting to win the battle against inflation.

Inflation in the US has started to moderate as energy prices have declined. Headline inflation has fallen to 6.5%, declining for six months straight after reaching a high of 9.1% in June 2022.

This is notable because it shows some of the global drivers behind rising prices are starting to moderate, such as high energy and food prices and transport costs, which will filter through to the UK.

However, there are also clear differences between the inflation challenge in the US and here in the UK.

To start with, the BoE and US Federal Reserve are taking different approaches. The central banks are raising interest rates to try and encourage consumers and businesses to save more and spend less. In theory, this should take money out of the economy and prevent prices from rising too fast.

The theory is the same on both sides of the Atlantic, but the approaches are different.

As McHugh says “The Fed was very aggressive in 2022, raising interest rates from 0-0.25% to 4.25%-4.5%, in order to get a handle on inflation. The BoE took slightly less aggressive steps to quell inflation, raising rates from 0.25% to 3.5%”.

The BoE has to be a bit more cautious as it’s fighting two different enemies, global factors and Brexit-specific factors.

The Resolution Foundation think tank reckons food prices rose 6% in 2020-21 due to new UK-EU trade barriers.

Another UK-specific concern as McHugh highlights is the fact the country is “suffering from worker shortages, leaving it on the hook for higher costs associated with potential wage growth.”

Wages grew at their fastest of 6.4% in more than 20 years (outside of the pandemic) for the September to November period, compared to the same time last year.

Private sector wages grew even faster, rising 7.2% overall and more than 10% in some sectors.

Wages are usually the biggest cost for businesses, so if they rise fast, they can put pressure on companies to raise the prices of their goods and services, feeding into core inflation.

The resulting higher inflation leads to demand for even higher wages, a difficult situation called the ‘wage-price spiral,’ and this is why high and persistent core inflation can be so challenging. Even if energy and food prices keep falling, the wage-price spiral can continue to drive prices higher.

What inflation means for you

Sticky core inflation indicates higher prices will continue to pierce consumers' pockets.

It also suggests the BoE will be forced to continue to raise interest rates further than other central banks as it tries to bring the CPI figure under control.

This in turn could mean even higher mortgage rates, which would hurt the already wounded UK property market. Housebuilder Persimmon estimates that some first-time home buyers are facing double the monthly cash costs they did last year.

Still, there could be a silver lining here. Lower property prices could improve affordability.

McHugh says “the likely slowdown that will ensue, will bring down house prices in the short term, and make them more affordable.” Indeed, the Office of Budget Responsibility (ORB) expects house prices to start falling this year, and this decline will only gather speed next year.

Savings rates have also started inching up. As the BoE continues to fight inflation, savers may continue to benefit from higher rates.

When will UK inflation fall?

“Inflation could potentially decline rapidly in the second quarter of 2023,” says Aquilante. In explaining why he adds “Aided by a mild winter, some of the key forces of inflation in 2022, such as energy prices, are abating significantly”.

McHugh echoes his views, saying that “Assuming we don’t have another flare-up in energy costs, the headline figures should trend lower to 6-7% by the summer.”

However other forecasters have said that it won’t decline to BoE’s target rate before late 2024 or early 2025. The BoE itself said in December 2022, that it will be “close to the 2% target in two years’ time”.

The key takeaway here is that even if it’s a while before inflation ceases to be a concern altogether, we should start to see some genuine relief much sooner - potentially even in a few months' time.