Will rising UK inflation limit interest rate cuts?

It’s a big week for data in the US and UK and, after last week’s gyrations, the markets will be watching the numbers even more closely. In the UK we get data on inflation and the labour market. When it comes to inflation, we are likely to see the end of the dramatic declines in the headline rate which has taken us from double digit figures just over a year ago to bang on the 2% target for the last 2 months. The best guess is that this week’s numbers will show headline inflation rising to 2.3%. Further increases to 2.7% by year end are likely. And the outlook for 2025 is not good either.

The Bank of England (BoE) looks through temporary movements in inflation, focussing on getting it sustainably towards the 2% target. Having made its first cut at the last meeting by the narrowest of majorities, recent developments will have made the committee even more cautious. There are two quite separate reasons for recent gloom over UK inflation: energy prices and wages. Much of the recent decline in UK inflation reflect movements in the OFGEM price cap for household energy bills. These more than doubled following Russia’s invasion of Ukraine and have since fallen by 40%. The price cap is now set to rise by 10% in October and will probably rise again in January.

Wages may prove to be an even bigger problem for the BoE. Although wage inflation has fallen from the highs it remains over 5% which is far too high to be consistent with the 2% inflation target. Figures out this week may show some improvement, but the underlying trend is for wage inflation to have edged higher so far this year despite the hefty declines in headline price inflation. The stronger economy is one reason but decisions by the new Labour government have made the outlook much worse. The pay award to junior doctors of 22% over two years coupled with the decision to award the 5.5% recommendation for public sector pay in full were both well above expectations. The public sector is a huge employer, and these numbers are likely to boost private sector pay. A more direct effect will come from the plan to further raise minimum wages relative to median wages next April. In the absence of a further relative move, the minimum wage might have risen by only 3.9% in April 2025. The outcome is now likely to be 6% or more.

A scenario whereby lower headline inflation leads to lower wage growth, allowing the BoE to cut interest rates despite improving economic growth has now been replaced by a much less optimistic outlook. The market is currently pricing in a further 50 bps of cuts by year end with another 50 bps by June 2025. I think we may see fewer cuts. Indeed, having been very optimistic about the prospects for UK growth, inflation, and interest rate cuts, I am now moving firmly in the other direction.

All is not lost though. If, as seems likely, the US starts cutting rates, this will strengthen sterling and improve our interest rate prospects. We should see better UK growth data and a drop in wage inflation over the rest of this year. But the balance of risks for the UK has changed, and not for the better, in my view.