Everyone knows that inflation has been too high. We all see it and feel its pinch every time we buy a coffee, complete the weekly food shop, fill up the car or pay the utility bill. But things are about to change. Inflation will soon be very low. It may even fall close to zero.
CPI inflation has been above the Bank of England’s 2.0% target since May 2021. At one point in October 2022 it reached a 41-year high of 11.1%. It has since fallen back to 3.4% in February of this year. Even so, over the past three years the average price of the goods and services we buy has risen by a whopping 21%.
What’s more, the UK has had a bigger inflation problem than the US and most of Europe. CPI inflation in the US peaked at a lower 9.0% and the high in the euro-zone was 10.6%. The total rises in prices over the past three years in the US and the euro-zone was smaller, both coming in at 18%.
But all this is about to change. When the data for April are released in mid-May, I suspect we’ll discover that inflation in the UK fell below the 2.0% target for the first time in three years. What’s more, my forecast is that inflation will fall below 1.0% in the summer and by the end of the year it may be just 0.5%. At that point, it wouldn’t take much of a further fall for inflation to disappear completely.
These falls will probably be driven by two developments. First, further declines in wholesale gas prices will mean that utility prices continue to edge lower. Second, the recent weakness of the economy (it hasn’t grown at all over the past two years) will mean businesses lose confidence in their ability to rapidly raise their selling prices.
These forces aren’t as great in the US or Europe. As a result, I expect that from April inflation will be lower in the UK than in the US and the euro-zone. That would mean the UK suddenly flips from having the worst inflation record to the best.
This doesn’t mean that all the prices we pay will be lower. This will be the case for some items. For example, petrol prices have already fallen by 19% from their peak, utility prices have dropped by 18%, second-hand car prices have declined by 12% and the prices of kitchen appliances have fallen by 6%. But the prices of lots of other items will remain high and will continue to rise. Even if food prices fall a bit, they are unlikely to reverse much of the 30% increase since the start of 2021.
Instead, lower inflation is mostly about prices still rising, just at a slower pace. What’s crucial is how the change in prices sits relative to the change in wages. For a chunk of the past three years, prices were rising faster than wages. That meant the monthly pay packet didn’t stretch as far. In economist-speak, “real wages” declined.
But since March last year, prices have been rising at a slower rate than wages. And my forecast that inflation will be unusually low over the next year implies this will continue. As a result, real wages may rise by just over 2.5% this year. That would be the biggest increase since 2007.
This doesn’t mean that all the financial troubles of households will disappear. But it does mean that their wages will stretch further. What’s more, if inflation is as low as I expect, the Bank of England will probably reduce interest rates from the current 16-year high of 5.25%. The first reduction to 5.00% may come in June and by sometime next year rates may be down to 3.00%. That would bring some further relief to those households with mortgages.
Overall, the UK is on the cusp of flipping from an economy beleaguered by high inflation to one benefitting from low inflation. I suspect a fall in inflation below 2.0% in April and below 1.0% later this year will be the catalyst for a marked improvement in households’ finances and a stronger economic recovery than most realise.
Paul Dales is Chief UK Economist of the independent global research consultancy Capital Economics
