Three reasons we may have reached peak inflation

As inflation hits its highest level for 41 years, we examine what's driving prices higher and three reasons why the worst may be over.

Today is Groundhog Day as inflation has exceeded expectations again, hitting 11.1% for the year to October, its highest level since 1981.

It’s a throwback to the days when Adam Ant ruled the charts, mobile phones cost $10,000 and Ipswich Town football club were riding high: yes, they really did win the UEFA cup in 1981!

But the economic picture in the early 80s wasn’t so pretty. The UK was in the middle of a severe recession, unemployment was 8.8% and interest rates were over 16%.

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Back to today and depressingly, figures released by the Office for National Statistics (ONS) this morning show inflation in the UK jumped by a whole percentage point during October 2022, largely driven by spiralling energy costs.

In total, electricity and gas costs have risen 90.2% since last year, largely driven by the war in Ukraine, but made worse by other pre-existing energy supply problems. In September, electricity and gas inflation was 'just' 69.2%.

The energy price cap meant that overall electricity, gas and other fuels prices rose by 24.7% between September and October this year, with gas prices rising by 36.9% and electricity prices by 16.9%. The increases would have been even higher without the government’s decision to subsidise the energy cap.

Victoria Scholar, head of investment, interactive investor said, “without the Energy Price Guarantee, electricity, gas, and other fuel prices would have risen by nearly 75% between September and October instead of 25%, which would have taken CPI inflation to approximately 13.8%.”

As well as energy costs, food prices also rose by 13.2% in the past 12 months, up from 11.8% in September. Food annual inflation has risen every month since Dec 2021 and is at its highest level since September 1977.

Higher than expectations

Most experts expected inflation to rise during October, as the previous energy price cap of £1,971 was replaced by a higher energy cap of £2,500. But worryingly, inflation was again higher than the 10.7-10.9% predicted by many analysts.

It’s yet another reminder of the volatility of the current global economy and the difficulty of controlling inflation in the short-term with monetary policy.

Wages may push inflation higher

Among the experts, the verdict is out on whether we have reached peak inflation. There are some indicators that we may not be out of the woods yet.

Mike Bell, global market strategist at JP Morgan Asset Management, says: “What has been underestimated consistently has been the inflationary pressures stemming from the tight labour market. 

“With headline inflation expected to stay elevated for some months yet, workers may still ask for more pay to protect disposable income.”

And there are signs that Rishi Sunak is worried about wages pushing inflation higher. Commenting at the G20 summit this week he said: “I would say to executives to embrace pay restraint at a time like this and make sure they are also looking after all their workers.”

Three downward pressures on inflation

But there are also three signs of downward pressures on inflation, that indicate we may have reached or be nearing the inflationary peak.

1) Interest rates

The Bank of England’s interest rate rises have a medium-term dampening effect on inflation, but they do take time to kick in.

In a speech last week, Professor Silvana Tenreyro, a member of the Bank of England’s monetary policy committee, commented on the delayed impact of the Bank's actions, and explained why it is reluctant to increase rates too quickly. She said: “Monetary policy has tightened significantly this year, but most of its effects on demand have yet to occur. Too high a path for Bank Rate therefore risks oversteering inflation below target in the medium term.”

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Because there’s a lag between raising rates and the impact on the economy, we should now start to see inflation reducing in response to rate rises last spring. Interest rates were ultra-low this time last year but have been steadily rising ever since.

2) Energy prices

Although energy prices are a short-term contributor to inflation, they also discourage consumer spending and therefore hold back inflation in the long run.

Professor Tenreyro explains that, “energy price increases push up inflation in the near term. But in the medium term, they have disinflationary effects through lower real incomes, lower demand and higher unemployment.”

And the energy price cap means that energy costs are fixed for households until April 2023, meaning that rising energy prices are unlikely to affect consumer inflation in the short term.

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Myron Jobson, senior personal finance analyst at interactive investor says: “It is hoped that the worst is now behind us, with inflation expected to ease back as the price of energy won’t continue to rise so quickly following the introduction of the energy price guarantee scheme. This freezes energy bills at £2,500 per year for the typical household until April. The loosening of post-pandemic supply bottlenecks and the rise in borrowing costs curtailing consumer demand (in theory) are also having a cooling effect on sizzling inflation.”

By the time the energy cap ends in April, it is hoped that other inflationary pressures will have eased, and that interest rate rises will have kicked in to start reducing inflation.

3) Austerity 2.0

Tomorrow’s Autumn Statement, with its expected tax rises and spending cuts, is also partly aimed at dampening consumer spending over the next few months and years.

Jeremy Hunt is doing the opposite of his predecessor, Kwasi Kwarteng, and is playing Scrooge in an attempt to control rapidly rising prices.

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In an interview with The Sunday Times, Hunt warned: “I think it is fair to say this is going to be the first rabbit-free budget for very many years.” Commenting on his planned tax rises and spending cuts, he said, “I’m Scrooge who’s going to do things that make sure Christmas is never cancelled.”

Inflation will remain high for some time

Although inflation may not rise much more, it’s likely to remain at historically high levels for some time. The Bank of England doesn’t expect inflation to fall significantly until the middle of 2023, and is currently predicting that it will remain above its 2% target until the end of 2024.

At the beginning of November, the central bank's Monetary Policy Report explained that, “In the MPC’s central projection, CPI inflation starts to fall back from early next year as previous increases in energy prices drop out of the annual comparison. Domestic inflationary pressures remain strong in coming quarters and then subside. CPI inflation is projected to fall sharply to some way below the 2% target in two years’ time, and further below the target in three years’ time.”

Of course, Bank of England projections have been wrong before and they could be wrong again. But while experts debate the likely timing of the peak, there are several positive signs that high inflation will fall in the medium term. We may not be out of the woods, but we can perhaps start to glimpse light at the end of the tunnel.