How will drop in inflation affect plans to raise UK interest rates? | Inflation

There is hope for households across Britain that inflation, finally, has peaked. After hitting a 41-year high of more than 11% in October as energy bills soared, the fall in the annual inflation rate in December for a second consecutive month will come as a relief.

However, prices remain high and are still rising fast. Lower inflation rates do not mean prices are falling for consumers; it is just that they are not rising quite as fast as a month ago. The cost of living crisis may be fading but it is very far from over.

At 10.5%, the UK’s inflation rate is still among the highest since the early 1980s. Double-digit price growth figures are rare in the UK, with the only comparable periods in history coming in the early 1950s and after the oil price shocks of the 1970s.

Over the coming months, households will still feel the pinch from high energy bills and the rising cost of a weekly shop. Even though overall inflation fell, the annual rate of price growth for food and drink accelerated again, soaring to 16.8%, the highest level since 1977.

There will be a view at the Bank of England that it is too early to declare victory. Threadneedle Street is widely expected to raise interest rates in early February for the 10th time in succession, up from the current level of 3.5%.

Cooling inflation could help ease pressure on the Bank. However, its rate setters are likely to view official figures showing resilience in the jobs market, and stronger than expected economic growth in November, as ammunition for a further rate increase.

However, the Bank must proceed with caution. Households facing the biggest squeeze on their living standards in decades are already cutting back their spending, business confidence is weak and earlier rate increases are yet to have their full impact. With the cost of living still high, these are significant headwinds.

Inflation is expected to fall back this year as the initial shocks from the Covid pandemic disrupting global supply chains, and Russia’s war in Ukraine driving up energy prices, work their way through the system. For these reasons, alongside the risk of a UK recession, the Office for Budget Responsibility forecasts inflation will drop below 4% by the end of 2023.

After the release of Wednesday’s figures, Jeremy Hunt warned that “difficult decisions” would still need to be taken to ensure it fell further. Saying the decline was welcome, the chancellor added: “We have a plan to go further and halve inflation this year.”

It is an odd comment to make, after the government claimed no responsibility for inflation heading in the opposite direction only a few months earlier – blaming “global factors” outside its control – and with forecasters anticipating a fall anyway.

Instead, ministers view controlling inflation as the reason to turn down bigger pay increases in the public sector, or offer tax cuts and higher government spending, to soften the cost of living crisis. It is a risky strategy.

Economists expect inflation to fall not because of government restraint but as high energy prices fade and global supply bottlenecks ease. While there is a risk of inflation persisting at higher levels, it must be balanced with the danger to the economy as households and businesses remain under pressure.

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