A personal view from Ian Stewart, Deloitte’s Chief Economist in the UK.

Inflation has fallen sharply in the US and in the euro area in recent months. In the UK it is stuck at 10.1%, only down marginally from its peak and twice US levels. We are frequently asked why this is. This week’s briefing offers a degree of reassurance. It looks as if the inflation gap is about to narrow.

High UK inflation is partly due to Britain’s reliance on natural gas whose wholesale price rose 14-fold between early 2021 and last summer’s peak. Prices have since tumbled but are still more than three times above what was considered a normal level before the pandemic.

Gas plays a far bigger role in the energy mix in the UK than in the US or Europe. 85% of UK households have gas boilers, less than half of EU households do. Gas accounts for 40% of UK electricity and 20% of EU electricity. Standards of insulation tend to be higher in the EU than in the UK.

Differences in the way in which higher wholesale gas prices are passed on to consumers have also played a role in sustaining UK inflation. 

At the onset of the energy crisis, household energy prices spiked a couple of months earlier in the EU than in the UK reflecting different mechanisms for setting consumer bills. Just as the feed through to bills was faster in the EU, so too has been the feed through of falling wholesale prices to EU consumers.

The UK government initially took the view that the best way to deal with the shock of higher energy prices was to pass on increased costs and give targeted support to low-income consumers. Some other euro area countries, including the Netherlands, took a similar approach, while others opted to cap prices. France, for instance, limited electricity price rises to 4% and froze domestic gas prices, with the difference covered by public subsidies. But with increases in wholesale gas prices far exceeding expectations, the UK changed tack in October 2022 and introduced a general subsidy, the Energy Price Guarantee (EPG). The UK’s later embrace of the EPG, initially opting instead for subsidies, meant that UK households experienced higher energy prices at the start of the crisis than the euro area average.

So higher gas use, lags and subsidies have all played a role in keeping UK inflation at double-digit levels. Things are, however, about to change. April’s UK inflation data, due to be released later this month, is likely to show the headline rate dropping from 10.1% to around 8.0% as the effects of higher gas prices in early 2022 fall out of the calculation. Headline inflation will fall still further in subsequent months as lower wholesale prices feed through to household bills.

The Bank of England last week raised its forecast for UK inflation, partly as a result of more resilient growth and easier fiscal policy. Nonetheless, the Bank sees inflation dropping to just over 5.0% at the end of this year and falling further in 2024.

While energy has played an outsize role in sustaining UK inflation, it is not the only factor. Stripping out energy prices, so-called core inflation is running at rather higher levels in the UK than in the EU or the US. There are several potential explanations for this gap. 

The UK is facing what the governor of the Bank of England, Andrew Bailey, has described as a unique “labour force shock” due to a surge in early retirement and long-term sickness. Between late 2019 and mid 2022, the number of working-age people who were outside the labour force, due to early retirement, sickness or studying, rose by around 800,000 people. This shrinkage of the workforce, which is unique among major industrialised economies, is likely to have contributed to wage and inflation pressures. Brexit has also played a role. It has contributed to higher import costs, a weaker pound and has dampened levels of investment. These effects are, however, likely to moderate with time.

UK inflation should fall more sharply through the rest of this year as lower energy prices feed through, with the annual rate more than halving by December. That is the easy part. Even if inflation drops to around 4.0% at the start of 2024, it will still be running at twice the Bank of England’s target rate. Lower energy prices will make a big difference, but there is a long way to go before inflation hits anything approximating normal levels.

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