Hazy inflation picture clouds this year’s interest rate decisions

UK CPI remained moderated again in March at an annual 2.6% partly thanks to a drop in petrol and diesel prices, a fallback that offers the Bank of England some room to manoeuvre on interest rate policy amid significant domestic and global uncertainty – by Rob Morgan, Chief Investment Analyst at Charles Stanley

In particular, there will be some comfort that services inflation, a significant factor that has dragged headline numbers away from target, eased from 5% to 4.7%.

The trend of gradually easing price rises is likely to be short lived though. Inflation is forecast to move in the wrong direction most of this year driven by higher energy and utility costs. The picture for the services component could change too as renewed pressure emerges from businesses looking to pass on additional employment costs that have taken effect this month.

The inflation rate is expected to jump to 3.6% when April’s data is released next month and could hit 3.75% in the third quarter according to the latest forecast from the BoE.

What does it mean for interest rates?

The BoE faces several conflicting forces that mean decision making is more difficult than usual.

The Bank has already said regulated price rises and the effects of the Budget could add around half a percentage point to the inflation rate by the second quarter. Many businesses will now be in the process of passing on NIC and minimum wage rises, which could fan the flames of services inflation and limit how far policymakers can go in terms of rate cuts.

Yet there are also early signs that the job market is weakening, the canary in the coalmine of a more difficult economic environment.

Job vacancies continue to tail off suggesting businesses are reining in their horns and pausing hiring, a natural reaction to the sudden increase in employment costs. This is likely to lead to a drop off in demand later this year and, eventually, less upward price pressure.

Meanwhile, the economic world has been shaken by the much larger than expected tariffs unveiled by the Trump administration. These stand to increase prices for US consumers, but the effect elsewhere is more nuanced.

The resulting disruption and higher cost of supply chains around the world is likely to put some upward pressure on inflation. However, certain goods may become cheaper to non-US buyers owing to short-term oversupply. The more significant threat is the potential downdraft to global growth generally, which as an open economy the UK will be fully exposed to. A slowdown can be disinflationary, but much will depend on the scale of the tariffs and extent of retaliatory action.

Overall, the Bank will be taking an open-minded view of the effects of these factors on the economy and on inflation. It will probably look past any one-off price shocks from tariffs and focus on the bigger threat of weak growth. Favourable movements in both the price of oil and the recent strength of the pound in currency markets may further embolden policymakers to take slices off interest rates as the year progresses. For now, a 25% cut to 4.25% at the BoE’s meeting in May looks highly likely, though the picture is much hazier for the rest of the year.