We are now past the worst of the cost-of-living crisis, but households could get a nasty shock later this year when UK inflation is expected to spike. The headline figure (as measured by the Consumer Prices Index) is expected to hit 3.7% in the third quarter of 2025, according to the latest forecast from the Bank of England.
A rise in global energy prices will be the main factor driving the increase. The Ofgem energy price cap rose by 1.2% in January and is expected to rise by a further 2.7% in April, according to a forecast from energy consultancy Cornwall Insight.
The good news is that the central bank believes domestic inflationary pressures are waning overall. However, we are still likely to see increases in some categories. For example, the introduction of VAT on private school fees from the start of January 2025 is expected to drive up the rate of inflation. Water bills will also rise by an average £123 per year from April.
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The Autumn Budget is likely to push prices higher too, after the government raised employers’ National Insurance contributions and the National Living Wage. Both measures will also kick in from April. Sixty-seven percent of businesses are planning to hike their prices this year in an attempt to offset these costs, according to a survey from the British Retail Consortium.
Collectively, the Bank’s Monetary Policy Committee (MPC) has said that regulated price increases and the effects of the Budget could add around half a percentage point to the rate of inflation by the second quarter of this year. This does not include the energy price rises discussed previously, which are also expected to add around half a percentage point between December 2024 and June 2025.
Is the rise in inflation a cause for concern?
Despite increasing its inflation forecast, the Bank of England cut interest rates in February 2025 for the third time since the summer, bringing the base rate from 4.75% to 4.5%. Two members of the MPC voted for an even bigger cut of 50 basis points.
Some commentators have argued that this pivot towards a more dovish approach reflects growing concerns about stagnation in the UK economy, with growth becoming more of a worry than inflation. The latest UK GDP report showed zero growth in the three months to November (versus the three months before).
Alternatively, the MPC might simply be less worried about the upcoming rise in inflation because it is being driven by global rather than domestic pressures. In its February report, the Bank wrote: “The MPC judges that this pickup in headline inflation will not lead to additional second-round effects on underlying domestic inflationary pressures.”
Indeed, services inflation has been a big area of focus for the Bank of England in previous months. This metric has been persistently high – a cause for concern given that services account for around 80% of the UK economy. However, we have now seen significant disinflation in this category, and it is likely to make further progress in the months to come.
The economists at financial institution ING write: “Services inflation, the Bank of England’s central focus, is no longer an outlier at 4.4%. It’s now similar to both the US and Germany.
“Admittedly, that’s set to rise back up to 5% or above in January’s data. Last month’s drop was helped by airfares, which failed to properly account for Christmas price hikes. But that’s noise, and our favoured measure of ‘core services inflation’, which strips out volatile/less relevant services, has been showing consistent progress. This gauge is at 4.5% and looks set to fall to 4.2% at the next reading.”
ING expects services inflation to fall even further to around 3.5% in the spring, when index-linked contracts like broadband and phone deals come up for renewal. These annual price hikes are linked to inflation, which has been less aggressive than a year ago.
In other words, the disinflation trend still seems to be firmly in place. While fluctuations in areas like energy can cause short-term pain for household budgets, there is no suggestion that we are heading back to the challenging days of the cost-of-living crisis.
UK inflation forecast: has the Bank of England got it wrong?
Although most people agree that inflation will rise in the months to come, not everyone agrees with the Bank of England’s assessment that it will hit 3.7%.
“Our forecast is much lower than the Bank’s,” says Ruth Gregory, deputy chief UK economist at consultancy Capital Economics. “We think the loosening in the labour market will feed through to a faster fall in wage growth, causing services CPI inflation to fall faster too,” she explains. There is currently a 0.9 percentage point difference between each of their forecasts.
The National Institute of Economic and Social Research (NIESR) is also more optimistic than the Bank of England when it comes to inflation. It expects January’s inflation reading to come out as 3.2%, up from 2.5% in December, before falling slowly back to target. It expects inflation to average out at 2.4% in 2025 as a whole.
Despite this, the NIESR is less bullish on the outlook for interest rate cuts, and is forecasting just two reductions to the base rate before the end of the year. Most economists, on the other hand, are expecting around four.
“Persistent wage growth this year, amid an expansionary fiscal policy and exchange rate depreciation, will all act to limit the scope for monetary loosening,” the NIESR explains.
The Office for Budget Responsibility (OBR) also publishes inflation forecasts twice a year, with its Spring Forecast due in March. The last OBR report, published alongside the Autumn Budget, indicated that inflation would average out at 2.6% in 2025, 2.3% in 2026, 2.1% in 2027, 2.1% in 2028 and 2% in 2029.
Despite this, there are several risks on the horizon which could influence the inflation outlook going forward. US president Donald Trump has already begun imposing some tariffs on imports, for example, which could prove inflationary if the situation escalates into a full-blown trade war.
