Interest rates to rise despite inflation falling

The government’s plan for the economy is “working”, Rishi Sunak claimed confidently, after new data revealed a sharp fall in July’s rate of inflation.

Yet a closer look at the ONS figures suggest his pledge to halve inflation by the end of the year could still be in jeopardy.

The rate of inflation fell for a second consecutive month to 6.8 per cent in July, down from 7.9 per cent in June, marking the biggest six-month change in 30 years. 

The widely anticipated drop was largely driven by lower gas and electricity prices. While food inflation is still high, the slower pace of price rises for staple food items like milk, butter, eggs and cereal also helped to lower the trend. 

The less good news is that prices paid by UK renters actually rose on average by 5.3 per cent in July, compared to 5.2 per cent the month before, meaning the rising cost of rent has hit its highest level since records began in 2016.

What’s more, services inflation – which measures the cost of services in bars, hairdressers, restaurants, hotels and so on – actually rose last month to 7.4 per cent – the joint highest level since 1992.

Many economists are blaming wage increases for stubbornly high services inflation. 

After a year and a half of price rises outstripping pay growth, wages are finally rising faster than inflation again, after they climbed on average by 7.8 per cent annually between April and June. 

Many will welcome the news that living standards are beginning to recover. But we must also remember that interest rates – aimed at taming inflation – only have their desired effect if they encourage the population to cut back on spending.

Financial analysts say wage increases are forcing up service costs, obstructing a fall in the rate of core inflation.

Core inflation – which excludes more volatile prices like food and energy – remained unchanged in July at 6.9 per cent. This is troubling since it’s considered a crucial indicator of underlying inflationary pressures and is a figure closely watched by the Bank of England when setting interest rates.

It means the Bank of England will almost certainly raise rates 5.25 per cent to 5.5 per cent when it meets in September, while some city traders predict rates will peak at 6 per cent.

Cebr is predicting that the CPI inflation rate will hit 4.4 per cent in December while the National Institute Economic and Social Research expects it to fall to 5.5 per cent by the end of the year. Even the latter forecast means Sunak would narrowly meet his pledge, which requires inflation to have dipped as low as 5.3 per cent in four months time. 

If it does, then the fall will of course be touted as evidence that the PM’s grand plan has worked, although everyone knows that the government has no real control over external factors such as global energy or commodity costs. As Heidi Karjalainen, a research economist at the Institute for Fiscal Studies points out, Sunak’s pledge to halve inflation by the end of this year was “always a little odd as there is only so much the Treasury can do to influence the pace of price increases.” 

If price rises prove too stubborn for Sunak to meet his target, prepare for more talk of the “global factors” at play. 

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