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Hopes that inflation will fall much quicker than the Bank of England expects have been boosted by a key commodity that feeds into its forecasts, lifting the UK’s economic prospects ahead of the general election expected this year.
Since the BoE’s Monetary Policy Committee voted to hold its benchmark interest rate at 5.25 per cent in December, data has shown price pressures ebbing faster than expected and mortgage rates falling on hopes of monetary easing.
Middle East tensions present a risk to that improving outlook, as some analysts warn of fresh gains in commodity prices. But official figures on Friday pointed to improving activity late last year, as gross domestic product strengthened in November, driven by a rebound in the all-important services sector.
“The indicators have been better for a couple of months now,” said Elizabeth Martins, economist at HSBC, referring to measures such as consumer confidence and the purchasing manager indices. “The word we keep coming back to is ‘perky’.”
The biggest factor for the UK’s immediate inflation outlook, however, is the sharp decline in wholesale gas prices. The market prediction for prices over the course of 2024 — on the measure that feeds directly into the BoE’s forecasts — has dropped below 80 pence per therm in the past week.
This is halfway through the period BoE staff will look at when they finalise the forecasts for February’s monetary policy report. Markets’ prediction was above 140 pence per therm when the central bank completed its most recent November forecasts.
Simon French, chief economist at investment bank Panmure Gordon, said the fall in markets’ prediction could be “the big driver” of a near-1 percentage point cut in the BoE’s forecast for consumer price inflation.
The BoE’s most recent forecasts showed CPI averaging 3.7 per cent in 2024 but subsequent data, showing price growth stood at 3.9 per cent in November, suggests it is already on track to undershoot that prediction.
Although the BoE has warned repeatedly that there is “some way to go” before it can be sure inflation is back to the 2 per cent target, investors are betting the central bank will begin cutting rates from the spring, taking them down to 4 per cent by the end of 2024.
Analysts are more cautious, saying there are still plenty of reasons for the BoE to be wary of making an early move.
Attacks on cargo ships in the Red Sea have not driven up freight rates far enough to affect consumer prices, but that could change if the disruption lasts longer, or if the conflict drastically pushes up oil prices. BoE governor Andrew Bailey told MPs this week that higher shipping costs would be “an issue in the monetary policy world”.
The unexpected jump in US inflation to 3.4 per cent on Thursday was a reminder that global price pressures are still bubbling. UK policymakers will want to see firmer evidence of wage growth slowing before they relax their stance, especially given the big rise in the minimum wage due in April.
Even if all goes well, the next drop in CPI is not expected until April, when regulated energy prices are next adjusted. Data published next week is likely to show the annual rate steadied at around 3.9 per cent in December.
Yet several economists have brought forward their calls on the timing of rate cuts on the back of better inflation news.
Andrew Goodwin, chief UK economist at consultancy Oxford Economics, said the BoE had been “too pessimistic about the stickiness of wage growth and services inflation” so that the drop in energy prices could bring inflation back to target as early as April.
He added that the central bank could use its February forecasts to “prepare the ground for rate cuts to begin in May”.
Philip Shaw, economist at Investec, said the MPC had recently “started to overpredict inflation” after underestimating inflationary pressures in 2021.
He said CPI inflation could be near 1.5 per cent by the third quarter of 2024, well below target, and that the first rate cut could now come in June, rather than August. The consultancy Capital Economics also now thinks the BoE will make its first move in June, rather than November.
Cheaper gas — combined with easier lending conditions and possible tax cuts — could also boost economic activity.
The UK economy grew 0.3 per cent between October and November, the Office for National Statistics said on Friday, following a 0.3 per cent contraction between September and October. That was stronger than the 0.2 per cent expansion forecast by economists in a Reuters poll.
The rebound reduces the spectre of a technical recession after GDP fell by 0.1 per cent in the three months to September, but it still leaves the economy in a decidedly subdued state.
French said output growth of about 0.5 per cent in the run-up to a general election would be a far cry from the expansion of 4.5 per cent in 1997, when Labour last won a landslide.
James Smith, economist at ING bank, said the recent sharp fall in market interest rates could have a “more tangible” effect on growth in the UK than elsewhere, because it would feed through to mortgage holders faster and give the Conservative government more room for pre-election tax cuts.
But Smith said “none of this means we should expect a dramatic or imminent acceleration in UK growth”, only that “the chances of a recession have fallen”.