By Shaan Raithatha, senior economist, Vanguard, Europe

 

Later this month, we will likely learn that UK inflation has fallen sharply. But don’t be misled by the headline numbers. The outlook for underlying inflationary pressures – what economists and central bankers call ‘core’ inflation¹ – remains too strong for comfort.

So much so, that we now think the Bank of England’s main policy interest rate could rise to as high as 5% and stay there for the rest of the year – if not longer.

One reason why UK inflation has remained high relative to other developed countries is due to the distinctive way British retail gas and electricity prices are set, with semi-annual price cap adjustments through the UK’s Energy Price Guarantee Scheme. But last year’s outsized energy price rise will soon drop out of the inflation calculation; come next month, the 47.5% month-on-month rise we saw in utility prices in April 2022 will no longer be part of the annual comparison.

It’s why we expect the annual rate of consumer price inflation to drop sharply from 10.1% in March, when the next set of data is released on 24 May.

(UPDATE: Actual data on 24 May showed annual inflation slowed to 8.7% in April).

While that expected fall may well grab attention, it doesn’t detract from the price pressures still bubbling beneath the surface due to the unexpected strength so far this year of the UK economy, particularly demand for services.

This is contributing to a resilient jobs market and pushing up wages, underpinning the ‘stickier’ outlook for prices. Core inflation, which strips out energy and food prices, has been tracking around 6% on an annualised basis over the past few months, as the chart below shows.

The trajectory of UK inflation over the last six years

Source: Vanguard, Office for National Statistics.

In short, because of the stronger economy, it’s now harder for the Bank of England to get inflation back down to its government-set 2% target², which is why we have revised our outlook for the UK economy. A summary of our new views follows below.

Vanguard’s UK 2023 forecasts

Sources: Vanguard. Notes: GDP stands for gross domestic product, which measures the size of an economy; CPI stands for consumer price inflation.

On the plus side, we expect economic growth in 2023 to be one percentage point higher than previously thought. But we also expect inflation and benchmark interest rates to end the year higher.

What might this all mean for clients?

Higher inflation for longer and potentially higher mortgages matter when thinking about a rainy-day cash fund. And it matters from an investing perspective since higher-than-normal inflation has the capacity to eat into real portfolio returns over the long-term, making it more important to ensure investment costs are kept to a minimum to help clients achieve their investment goals.

It’s a reminder also to make sure client investments are globally diversified across different markets.

We still expect the UK economy to experience a recession – or two consecutive quarters of negative growth – later this year, but we acknowledge that it will likely be shallower than previously expected.

It does mean, though, that recovery next year will likely be even more modest as higher interest rates weigh, which is why we’ve cut our UK 2024 GDP growth forecast to 0.2% from 0.6%.

So, it’s perhaps good news, economically, in the short term, but potentially more of a challenge further ahead.

 

¹ UK consumer price inflation excluding energy and food.

² See here for more on the Bank of England’s inflation target.