Economic update: Inflation not falling as fast as expected

For the first time since summer 2022, the inflation rate has dropped below 10%. Further declines are expected as energy bills eventually begin to fall later this year. However, inflation in other parts of the economy, such as food, are proving more persistent than had been anticipated.

This Insight concentrates on recent economic developments and the outlook for inflation, as well as some recent upgrades to GDP growth forecasts.

The inflation rate fell in April 2023…

After seven consecutive months of being over 10%, the annual inflation rate in the UK dropped to 8.7% in April 2023. This compares with 10.1% in March 2023 and a peak of 11.1% in October 2022.

This drop in the inflation rate was not as large as expected. Economists surveyed by Reuters expected inflation to fall to 8.2%, while the Bank of England expected it to fall to 8.4%.

The annual inflation rate is defined as the change in average prices compared with those in the same month the year before.

The fall in the inflation rate in April was mostly because last year’s sharp increase in household energy bills was not repeated this April, reducing the contribution of energy to the overall inflation rate. The chart below shows the changes in the inflation rate since 2018.

Economists expect the inflation rate to continue to fall over the rest of 2023. This is partly due to large rises in the prices of goods and energy in 2022 no longer being included in the annual price comparisons. In addition, lower wholesale energy costs are expected to result in lower household energy bills later in 2023.

The big question is how much will the inflation rate fall by? In early May, the Bank of England forecast that it would drop to 5.1% in the final quarter of 2023. This was, however, higher than its previous forecast of 3.9% made in February.

A lower annual inflation rate does not mean prices are falling, but that prices are going up less quickly.

…but underlying inflation is rising

Apart from energy costs, data from the Office for National Statistics (ONS) show price rises in the rest of the economy remain stubbornly high. Food prices rose by 19.0% in the year to April 2023, only a touch below the 19.1% recorded in March, a 45-year high. Between April 2021 and April 2023, food prices have risen by more than a quarter (27%).

Measures of underlying inflation in the economy rose in April 2023. The ONS reported that “core” inflation, which excludes energy and food, rose from 6.2% in March to 6.8% in April, its highest rate since 1992. Economists had forecast core inflation to remain at 6.2%.

The annual rate of inflation for services increased from 6.6% in March to 6.9% in April, also the highest since 1992. Services prices are seen as being less exposed to global factors than goods mostly because labour costs, which are less affected by the international economy, make up a large proportion of costs to many services firms. Inflation in services is also considered to be more persistent than inflation in goods.

The rates of core inflation and services inflation since 2018 are shown in the charts below.

Interest rates expected to rise further

In response to inflation being well above its target of 2%, the Bank of England’s Monetary Policy Committee (MPC) has raised interest rates at 12 consecutive policy meetings. Rates have gone up from an all-time low of 0.1% in December 2021 to 4.5% at the MPC’s meeting in May. The Bank of England interest rate since 2006 is shown in the chart below.

In the aftermath of the higher-than-expected inflation data for April 2023, financial markets expect the MPC to continue to raise rates, including at its next meeting in June.

Higher interest rates raise borrowing costs, which lowers demand for goods and services in the economy. This in turn reduces pressure on firms to raise prices.

The Bank of England’s most recent analysis of the UK economy noted that the full effects of past interest rate increases have not filtered through the economy yet. It said this was largely due to around 85% of all mortgages having fixed interest rates, usually for two or five years.

As a result, mortgage bills for many have not yet gone up since the Bank started raising rates. The Resolution Foundation think tank estimates that mortgage payments have gone up for only half of the households that will eventually be affected.

2023 GDP growth forecasts upgraded

In the past few months, there has been a steady stream of evidence suggesting that economic growth has been more resilient than was previously expected earlier in 2023.

This has led some economists to increase their estimates for GDP growth in 2023. For example, in November the Bank of England forecast a long shallow recession, but it now expects growth of 0.25% in 2023 and 0.75% in 2024. The International Monetary Fund also now thinks the UK will avoid a recession, forecasting GDP growth of 0.4% in 2023, up from its forecast of -0.3% made in April, and around 1% in 2024.

Nevertheless, as the Bank of England noted in understated fashion about its own forecasts, economic growth at these rates is “still subdued by historical standards”.

About the author: Daniel Harari is a researcher at the House of Commons Library, specialising in UK and international economies.

Photo by Nick Pampoukidis on Unsplash