Why lower inflation should cause the Bank of England to tread carefully


And breathe.

The City and Bank of England have waited a long, long time for the Office for National Statistics to provide some good inflation news.

It is the first time that headline inflation has undershot analysts’ expectations in ages. The Bank, after months and months of people slamming its economists for being so wide of the mark on forecasting the rate of price growth, can finally boast it has got one right, nailing its CPI projection.

Markets, households and businesses have become accustomed to receiving glum news on the cost of living. With the tide possibly turning, where does this leave us?

First up, the next batch of numbers, for July, should also bring relief.

This month saw the energy regulator Ofgem’s lower price cap of around £2,000 take effect, which will have a marked downward impact on inflation. We could even see CPI hug closer to seven per cent.

There are signs in more timelier data that other categories that have cooked up strong price pressures are ebbing.

According to S&P Global and the Chartered Institute of Procurement and Supply’s latest services purchasing managers’ index, input cost inflation for the sector has whittled down to its lowest level since May 2021.

“Some of this disinflationary pressure might emerge towards the end of this year – a little earlier than usual,” Samuel Tombs, chief UK economist at Pantheon Macroeconomics, said today.

Others were more cautious, urging onlookers to not extract judgements from one batch of data. Services and core inflation is still very high, something the Bank of England would have noticed in today’s figures.

Wages are still climbing quickly, up 7.3 per cent over the year to May, a joint record high, though still lagging behind price increases.

The concern is that workers continue to demand high pay rises even after inflation drops below pay settlements, which may cause sticky price dynamics to hang around. However, it is not just wages that contribute to firms’ costs. Research suggests businesses have beefed up profits more than pay when compared to before the pandemic. These things are never black and white.

Bank of England Governor Andrew Bailey and the rest of the monetary policy committee (MPC) must now tread very carefully. Tighten policy too much, they risk overkilling inflation at the expense of growth and making any recession worse than needed.

The bulk of the effects of their previous interest rate rises have yet to hit the economy, though that will change over autumn and winter when more and more people remortgage at much higher rates. Spending could suffer as a consequence.

Nearly everyone in the City is convinced inflation is on course to fall quickly over the second half of this year, even with borrowing costs at their present level of five per cent.

The MPC’s impulse to back another large 50 basis point increase in August should have weakened after today’s numbers.

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