Inflation moving in right direction but vulnerable to external shocks

Inflation fell to 2.6% in June, marking a welcome piece of good news for the incoming prime minister and his chancellor as they look to set out their policy agenda.

The escalation of tensions in the Middle East in February led to fears of inflation spiralling out of control, as supply chains were disrupted and oil prices surged. However, while inflation has remained consistently above the Bank of England’s two per cent target, it remains far below expected levels – in its World Economic Outlook published in April, the IMF predicted inflation to head towards 4% by the end of the year.

For Andy Burnham, the easing of inflation creates a more stable platform for his fledgling administration. As he looks to support those struggling with the cost-of-living crisis and encourage job creation, lower inflation rates will help to improve household spending power and boost business confidence, as long as earnings growth continues to outpace price rises.

But there is no room for complacency. A key contributor of falling inflation in recent months has been the cooling price of Brent crude oil in recent months, only beginning to rise again in July following renewed geopolitical hostilities. This reminds us how vulnerable the Treasury and Bank of England are to external shocks and headwinds in the global economy, and that the long-term inflation trajectory for the UK is largely out of their control.

Another important reason inflation hasn’t risen higher is because the economy is failing to kick into gear. Inflation remains more subdued than expected because weak consumer demand is suppressing activity in the economy, preventing prices from being driven up too high. In this case, falling inflation is a side-effect of a sluggish economy, not a flourishing one.

Today’s inflation data is a step in the right direction. If the current path can continue, then the Bank of England may not be forced into raising interest rates, and we could even see cuts again by early next year. But this shouldn’t be taken for evidence of an economy under control. The UK economy remains acutely vulnerable to being knocked off course, and inflation expectations in the long-term remain unclear.

Emeritus professor Joe Nellis, economic adviser at accountancy and advisory firm MHA