Why the rise in inflation might actually be... good news

The headlines don’t paint a pretty picture, admits Sean O’Grady, but behind the scenes, it is relatively positive for interest rates, borrowers – and the economy as a whole

‘The overall picture shows the UK treading a very narrow path towards modest economic growth’ (PA Wire)

Inflation is up… and that’s, erm, good news. No, really. Hear me out.

It is, in fact, relatively good for interest rates, for borrowers, and for the economy as a whole, and for very good reasons. The first is that the rise in the annual rate for July (the change in prices since July 2023) at 2.2 per cent is actually very slightly smaller than the markets were expecting.

It’s not purely a psychological thing, like being relieved when your energy bills don’t go up by quite as much as they have been doing (although that is actually the case); it’s also a real-world one, in the sense that market expectations really do matter.

Both the Bank of England and investors will look at these figures – and the underlying trends – and conclude that inflation is still moderating from what were extremely high rates (double figures) in 2022. That is good news. A small cut in the Bank rate from the current 5 per cent to, say, 4.75 per cent in September, October or November is slightly more likely now than it seemed yesterday.

Of course, everything is relative. Energy prices haven’t fallen back to their old levels since before the war in Ukraine caused the spikes in wholesale gas and oil prices. Yet they have been coming down during 2023 and this year, so an index of prices reflects the fact that they’re falling (while not falling as fast). They are also nowhere close to being back to “normal” – and may never be, for as long as there are sanctions on Russia.

Some costs actually fell, too – such as going out to a restaurant, or staying at a hotel. Bills for this type of activity came down this year, having risen last year.

Even more important is that underlying or “core” inflation is showing a better trend. The key statistic here is called “Core CPI”: a consumer price index that excludes more volatile costs, such as housing, energy, food, alcohol and tobacco. Prices overall on this definition rose by 3.3 per cent in the year to July 2024 – down from 3.5 per cent in June 2024 and below the recent high of 7.1 per cent in May 2023, which was the highest recorded increase since 7.2 per cent in March 1992.

The core inflation trend confirms what we saw in the data on wages that came out yesterday: prices/costs still going up, but the rate moderating across the past 18 months or so.

That means the Bank of England can take comfort from the way that its increases in Bank rate (it started pushing them higher in December 2021) have had the desired effect, applying steady but gentle pressure.

Broadly speaking, it takes about a year or two for the effects of rate changes to work their way through the economy, as people remortgage and companies roll over debts and the downward pressure on demand and prices becomes fully felt. Therefore, the Bank is looking towards pressures in 2025 – and there’s some encouragement to be found in what’s been achieved so far.

All that said, “domestic” inflation – the dreaded wage-price-wage spiral – is still too high for comfort, and in some respects is proving very persistent because of the UK’s post-Brexit and post-pandemic labour and skills shortage. These are becoming intractable at a time when immigration (while high) is so unpopular.

So, we may expect continuing caution from the Bank, and that the decisions made by the Monetary Policy Committee will continue to be unusually close and well balanced. They will also feel more confident because of the way Rachel Reeves is running a fairly tight fiscal policy, which supports the Bank’s efforts.

The overall picture shows the UK treading a very narrow path towards modest economic growth, but continually menaced and constrained by the threat of an acceleration in price inflation. So don’t expect anything too dramatic to happen (in either direction) on interest rates over the next few months.