The Economist | UK Economy Faces Dual Threats of Inflation and Recession

Worse, consumers also expect longer-run inflation to be higher. Adjusting a Bank of England survey for a shift in sampling around the pandemic, Pantheon Macroeconomics, a consultancy, reckons that five-year inflation expectations are close to their highest since the bank’s survey began 15 years ago. A survey by Citigroup, a bank, and YouGov, a pollster, shows a similar rise. There is little central bankers fear more than rising long-run inflation expectations; unless households and firms believe that inflation is anchored near its target, short-term rises can easily spiral out of control. Reining in post-pandemic inflation would have been far more painful had Britons not seen the Bank of England’s target as credible. So why is inflation persisting, and might it get worse?

UK Inflation Rises Ahead of Central Bank’s Rate Decision, Narrowing Room for Policy Inaction

UK inflation rose further ahead of the central bank’s interest-rate decision, as the energy-price shock continues transmitting to household bills and consumer spending, squeezing the Bank of England’s room to hold rates steady. On September 16th, the UK Office for National Statistics reported that the consumer price index (CPI) rose 3.1% year-on-year in August—up from 2.9% in July and the highest since March this year, in line with market expectations. Rising petrol and diesel prices were the main drivers, while higher household energy bills also contributed to the overall inflation uptick. The Bank of England’s Monetary Policy Committee (MPC) is set to meet on Thursday. Markets widely expect the bank to hold its benchmark interest rate unchanged at 3.75%. However, if the energy shock continues pushing inflation higher, markets have begun pricing in the possibility of a rate hike as early as November. Following the release of the inflation data, traders’ implied probability of a rate hike this week fell—from 35% to 25%—indicating that markets still see the bank as highly likely to maintain its wait-and-see stance in the near term. Meanwhile, rising inflation is also increasing fiscal pressure on the government. UK government bond yields have surged recently, shrinking the government’s fiscal space by more than half, according to estimates—further constraining policy flexibility ahead of the October budget announcement. Energy Prices Drive Inflation Upward August’s acceleration in inflation was primarily driven by energy prices. The UK Office for National Statistics noted that sharp increases in petrol and diesel prices were the top contributor to the monthly CPI rise, with airfare prices and factory-gate prices also adding upward pressure, while higher household energy bills provided further support. In early July, the UK energy regulator Ofgem raised the household energy price cap by 13%, directly lifting electricity and gas prices. At the same time, Brent crude oil has recently rebounded above $100 per barrel, and Ofgem has already announced plans to raise the energy price cap again in October—suggesting that energy prices may continue supporting inflation over the coming months. David Rees, Schroders’ Head of Global Economics, said UK inflation could rise further over the coming months, as energy, industrial goods, and food prices continue passing through to end consumers. According to the Wall Street Journal, markets currently expect UK CPI to reach or even exceed 4% early next year—twice the Bank of England’s 2% target. Core Inflation Remains Stable, For Now Leaving Room for Central Bank Inaction That said, the broad-based rise in headline inflation does not yet signal a widespread diffusion of price pressures. The core inflation rate—which excludes energy and food—held steady at 2.6% in August, while services inflation—a key focus for the Bank of England—remained stable at 3.4%. This suggests that current inflationary pressures remain largely concentrated in external factors such as energy, rather than evolving into broader domestic price pressures. Francesco Pesole, ING strategist, stated there is ‘still no evidence of inflationary pressures spreading beyond energy’, lending support to dovish voices within the central bank.

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