Inflation fell in February and looks set to fall further during 2024, raising the likelihood that the Bank of England will start to cut interest rates by the summer.

This Insight summarises recent developments in inflation and how they might affect future interest rate decisions. It also looks at whether the UK’s technical recession has ended and what this means for the UK economy, which has not grown since early 2022.

Inflation falls to lowest since September 2021

After peaking at a 41-year high of 11.1% in October 2022, the UK inflation rate (the change in consumer prices over the past 12 months) fell from 4.0% in January to 3.4% in February 2024. This was the lowest rate since September 2021, when inflation was on the way up, as shown in the chart below.

The falling inflation rate is due to lower energy prices compared with a year ago, as well as slower increases in food prices in recent months.

It looks like inflation will continue to fall. The Bank of England’s Monetary Policy Committee, which sets interest rates, expects inflation will drop slightly below its 2% target in the second quarter of 2024. This view is shared by other economists.

The energy price cap for households will fall in April, bringing down the inflation rate further.

A chart showing the UK’s inflation rate since 2017. Inflation fell from around 3% in 2018 to less than 1% in 2021. It then rose to a peak of 11% in 2023, after which it fell to 3.4% in February 2024.
Source: ONS monthly outturn data up to Feb 2024, then Q2 2024 quarterly expectation from Bank of England staff via MPC minutes of 21 March 2024

Inflation is expected to remain around 2% for the remainder of 2024, according to average forecasts from economists in a survey by Bloomberg, the financial news and data provider.

However, falling inflation will not reverse previous steep increases in prices. Average consumer prices were 21% higher in February 2024 than three years before, in February 2021.

Further information is available in the Commons Library briefing Rising cost of living in the UK.

When will interest rates be cut?

According to The Guardian newspaper and Reuters news service, financial markets and economists expect the Bank of England’s Monetary Policy Committee to respond to falling inflation by reducing its benchmark interest rate to 4.5% by the end of the year. The first rate cut is expected after policy meetings in June or August (the next meeting is in early May), but expectations can be volatile and change quickly.

The falling inflation rate has been welcomed by Bank of England Governor Andrew Bailey, who told the Financial Times  it was “very encouraging and good news”. Mr Bailey chairs the Bank’s Monetary Policy Committee.

The committee is required by the government to target an inflation rate of 2%. It raised rates from 0.1% in December 2021 to 5.25% in August 2023. Raising rates makes borrowing more expensive and saving more attractive, which is intended to reduce demand for goods and services and curb the increase in prices. The committee has since left rates unchanged, including at its March 2024 policy meeting.

At 5.25%, rates are at their highest level since 2008. High interest rates tend to limit economic growth because they reduce demand for goods and services.

Services inflation remains high

When setting the bank’s interest rate, the Monetary Policy Committee has considered other measures of inflation that reflect domestic costs (such as wages), which have not fallen as much as the overall inflation rate.

One such measure is inflation in services prices, which fell from a 31-year high of 7.4% in July 2023 to 6.1% in February 2024, but remains high, as shown in the chart below.

A chart showing how core inflation (which excludes food and energy prices) and services inflation have changed since 2019. Both measures declined gradually from around 2% in 2019 to around 1% in 2021, then increased to peaks of around 7% in 2023. Both have since fallen again: core inflation is around 4.5% and services inflation is around 6.1% in February 2024.
* CPI excluding food, beverages, energy and tobacco
Sources: ONS, CPI measure of inflation, series DKO8 (core) and D7NN (services); monthly data to Feb 2024

The Monetary Policy Committee is concerned that if services inflation doesn’t fall further, the overall inflation rate might remain above its 2% target over the next few years.

However, after the latest meeting, Governor Bailey seemed more confident that the downward trend in services inflation would continue. He highlighted to the Financial Times the lack of “second round effects”, such as a vicious circle of high wages and higher inflation.

Is the ‘technical recession’ over?

UK economic output shrank during the second half of 2023, with GDP falling by 0.1% in the third quarter (Q3) and by 0.3% in Q4. These two consecutive quarterly contractions in GDP meet the definition of a ‘technical recession’.

Although this definition is simplistic, ignoring other indicators – such as the continued low rate of unemployment – and context, the UK economy has been stagnating since the beginning of 2022, with GDP 0.1% lower in Q4 2023 than in Q1 2022.

During this time, the economy has faced rapidly rising energy prices, largely a result of the conflict in Ukraine. Rising energy prices abroad particularly affected the UK because it is a net importer of energy.

Available economic data for early 2024 suggests this technical recession may be over. For example, monthly GDP for January 2024 was up by 0.2% compared with December.

In addition, retail sales bounced back strongly in early 2024 following falls at the end of 2023. A prominent survey of business activity, the S&P Global/CIPS purchasing managers’ index has also recorded rising business activity (PDF), as the chart below shows.

A chart showing the purchasing managers’ index (indicating business activity) for the services and manufacturing sectors since 2019. The index for both sectors has risen slightly since mid-2023.
Source: S&P Global/CIPS United Kingdom PMI, monthly data, Mar 2024 figures (PDF) are flash estimates.

The Bank of England expects GDP to grow by 0.1% in Q1 2024, which would be enough to end the technical recession, although not the extended period of stagnation the economy is experiencing.

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

Photo by Eduardo Soares on Unsplash