Key Takeaways
- UK inflation is on the up and CPI numbers for the year to January jumped to 3% from 2.5% the previous month. Energy prices will rise 5% in April and council taxes and water bills are also increasing.
- Despite this trend, the Bank of England cut interest rates earlier this month – a move prompted by their view that the labour market is weakening. But wage inflation is tricky to forecast.
- Central banks have managed to get inflation down without triggering a sharp rise in unemployment. Can the Bank of England maintain this balancing act?
- Further out we see scope for pressures to ease as energy bills fall in 2026, the government’s growth agenda kicks in and public sector wage increases become much smaller. In the meantime, the Bank of England should keep interest rates on hold.
UK inflation is headed higher. Last week we saw a steep rise to 3.0% in the year to January for headline CPI. It was up from 2.5% the previous month and there is worse to come. April will see a 5% rise in energy prices coupled with big increases in council taxes and water bills. Companies will be raising other prices too: they must finance the increase in National Insurance contributions and the hefty 6.7% increase in the minimum wage – some younger workers will get an even bigger rise.
Against this background, the decision by the Bank of England to cut interest rates by one quarter of a percent earlier this month looks distinctly odd. They justified their decision on the basis that a weakening labour market will cut wage growth sufficiently fast to bring inflation back down to their 2% target. But they have demonstrated that they are unable to forecast wage inflation: it is currently running well above the level that they projected a year ago and well above the level that is consistent with the 2% inflation target. Their own surveys show companies plan to raise wages by well above the 3% that would be consistent with meeting their target.
One of the remarkable things in the battle against inflation in the developed world in the last year or so is that great success has been achieved without a rise in unemployment. Much of that success reflects the confidence that people have that their respective central banks will get inflation back to the 2% targets. The Bank of England now run the risk of losing credibility as higher inflation becomes embodied in expectations. The increase in the minimum wage, coupled with the rise in National Insurance complicates their task.
Over the next three months, both inflation and unemployment are set to rise. Because the minimum wage limits the ability of firms to reduce their wage bills, many low margin, labour intensive businesses will be forced to cut employment. Some will simply go out of business. Those that remain will put up their prices, so inflation looks set to rise towards 4%. It might not quite get there but it is clearly headed in the wrong direction.
There is light at the end of the tunnel. Although energy bills are rising this year, they are set to fall in 2026 and beyond as more LNG supply comes on stream and increases in renewable energy sources help meet demand. The government’s growth agenda will increase investment as the planning system is unblocked. The Chancellor has already submitted a much lower proposal for public sector pay this year and we can expect a much smaller rise in the minimum wage in 2026. But all this takes time and, meanwhile, the Bank of England should keep interest rates on hold.
