Lower UK inflation unlikely to faze Bank of England

Higher petrol prices lifted UK inflation in January, but this is unlikely to last. We expect headline CPI to fall from the latest figure of 1.8% to around 1.1/1.2% by June, as falls in household energy costs trickle through. Sharp cuts to water bills, as well as a lower regulated energy cap, should become a fairly noticeable drag on inflation.

Of course, none of this will come as much of a surprise to the Bank of England, which is more concerned about the fairly muted level of core services inflation. This is one of the better measures of what policymakers call “domestically-generated inflation”, and with wage growth having risen over the past couple of years, core services CPI would have been expected to rise in tandem.

We think a rate cut looks fairly unlikely for the time being

But this hasn’t really happened, which suggests margins have become compressed. Will this change now that optimism is rising again after the election? Part of the answer depends on whether firms feel they have greater pricing power to pass on these higher wage costs to shoppers. Despite some early signs that consumer confidence recovered a little after the election in December, we suspect competitive pressures and ongoing lack of demand in some retail segments will still make it challenging for retailers to lift prices more quickly.

At the same time, skill shortages in various industries (notably construction and hospitality) are unlikely to fade, and this will continue to maintain structural upward pressure on wage growth in some sectors.