One of the surprises of the Budget was the rise in the Office for Budget Responsibility’s inflation forecast for 2022 to 4% (average across the year) despite frozen fuel duties and a squeeze on some alcohol duties. The figure is in line with Cebr forecasts but until recently officials in both Whitehall and Threadneedle Street had seemed unaware of rising inflation.
But the OBR still expects a fall to 2.6% in 2023 and 2.1% in 2024.
Whether this will happen is very much up for debate.
It depends on:
1) Whether the world economy will start to overheat leading to high energy prices and supply shortages;
2) Whether the same continues in the UK, exacerbating the supply conditions; and
3) Whether the tightness of the UK economy next year spills over into the labour market.
The official forecast has output above trend not just in 2022 but also in 2023 and 2024 which would suggest that fuel will still be being added to the fire then!
The tightness of the labour market is not just due to strong demand but also because of changes that have affected the labour supply. Brexit has affected the flow of migrants at the same time as data show that many older workers have decided not to get back into the rat race post furlough and Covid, with the latest data showing inactivity levels of those aged 50 to 64 5.8% higher than the 2019 average.
The Monetary Policy Committee meets next week to announce decisions on the continuation of Quantitative Easing and on interest rates. These decisions will be made public at lunchtime on Thursday.
Their decisions will need to take into account the costs of getting it wrong either way. On our calculus, since rates are likely to rise anyway, there is little cost from moving slightly too early, since such a move can easily be offset by making the next move slightly later than might otherwise be the case. We continue to expect that the Bank will be forced to raise rates over the next two years to constrain inflation to between at least 1%.
The markets are pricing in a rise of 15 bps. Our guess is that the Bank might be tempted to go just a little further and raise rates by an additional 25bps to 0.5%. They will still be low but could start a trend to reprice property and financial assets. If this does happen it might limit the scale of further rate rises.
For more information please contact: