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The recent surge in inflation to three percent is indeed troubling, but it was largely anticipated. The pressing question now is whether inflation will escalate to four percent later this year. The rise can be attributed to a mix of external pressures, robust wage growth, and the delayed effects of Rachel Reeves’s Budget from last October.
The Bank of England had already predicted that consumer price inflation would likely reach 3.7 percent by summer. The current increase is simply occurring slightly earlier than forecasted. The three percent figure refers to the Consumer Price Index (CPI) measure. When considering the CPIH measure— which incorporates owner-occupied housing costs and is regarded as a more accurate reflection of real inflation— the inflation rate has already hit 3.9 percent. The older Retail Prices Index (RPI) shows a rate of 3.6 percent. Thus, across all metrics, inflation is significantly above the target rate of two percent and is expected to climb higher throughout the remainder of the year.
Inflation Matters
From a political standpoint, this situation poses serious challenges for Rachel Reeves. Although she is not directly responsible for these inflation figures—since monetary policy has been the purview of the independent Bank of England since 1997—these developments complicate her role for several reasons:
- Interest Rate Decisions: The prospect of further interest rate cuts may need to be reconsidered. Earlier this month, the Bank’s Monetary Policy Committee reduced rates by a quarter percent to 4.5 percent. However, given the current inflation data, justifying any additional cuts will be challenging. Interest rate adjustments are the primary tool the Bank uses to combat inflation, making it difficult to lower rates amid rising inflation.
- Government Decisions: To a degree, the recent rebound in inflation can be traced back to government decisions. For instance, the introduction of VAT on private school fees caused significant cost increases for some families, contributing to the overall inflation rate. The education sector experienced an annual inflation rate of 7.5 percent in January. Additional price hikes are anticipated due to the Budget’s impacts in April, including higher tobacco duties. Furthermore, the government’s energy policies aimed at achieving net-zero emissions have led to increased energy bills, making the UK’s electricity costs among the highest in OECD countries.
- National Debt Implications: Higher inflation also has repercussions for the Chancellor regarding the cost of servicing national debt. Over a quarter of the country’s debt is tied to index-linked gilts, meaning that any rise in the RPI directly raises the burden on taxpayers. Moreover, inflation typically drives up long-term borrowing costs, as investors demand higher returns to counteract inflation’s eroding effect on their holdings. For example, 10-year gilts are now yielding 4.6 percent, an increase from 4.3 percent just before Rachel Reeves’s Budget.
Next Steps for Reeves
We will not have a complete understanding of the fiscal situation until the Office for Budget Responsibility releases its report during the Spring Statement on March 26. However, there is widespread speculation that it will reveal that the financial flexibility Reeves had previously built into her calculations has been significantly diminished. The combination of slower-than-expected growth and higher-than-anticipated inflation has likely eroded her safety net. What strategies will she adopt moving forward?
Realistically, breaking her own fiscal rules is not an option. These regulations are enshrined in law, and maintaining credibility with the markets is crucial. Moreover, increasing taxes further is not a viable solution. While higher inflation does provide some relief by pulling individuals into higher tax brackets despite stagnant real wages—due to fiscal drag—raising headline taxes could further undermine confidence and would be difficult to implement. Consequently, she will need to explore ways to cut government spending, which will also prove to be a significant challenge.
Of course, as noted by the Institute for Fiscal Studies last month, she could potentially benefit from favorable circumstances: there may be unexpected growth, global interest rates could decline, or inflation could begin to ease. However, the current trends do not suggest a positive outlook. If these inflation figures spell bad news for Rachel Reeves, they likely signal troubling times ahead for the broader economy.
Need to Know
In moments of undeniable bad news, it’s always prudent to consider the “what ifs.” The IFS’s point about Reeves potentially getting a stroke of luck is salient. One must wonder, if the economic outlook is so dire, why are stock markets thriving? The FTSE 100 index experienced a minor dip on Wednesday but remains up 0.5 percent year-to-date. Interestingly, the German economy is reportedly facing even graver challenges than the UK, yet the DAX has shown impressive resilience, up 12 percent for the year.
While I cannot provide a definitive answer to this paradox, a positive perspective from Longview Economics—a London-based consultancy focused on long-term economic trends—suggests that it’s often darkest before dawn. Their latest analysis posits that the ongoing housing boom could underpin growth in the coming years.
According to Harry Colvin’s report, “Housing is central to the UK’s growth strategy, acting as a key driver of wealth effects and consumer confidence. As the housing market rebounds, consumer spending and borrowing are poised to accelerate. Notably, the household savings rate remains elevated, indicating a capacity for increased spending, while households are experiencing positive growth in real, post-tax discretionary cash flow this year and into the next.”
Is this perspective accurate? I find it quite convincing. Despite last year’s challenges, Land Registry data reveals that property prices rose by 4.6 percent over the year. If such growth can persist amid prevailing adversities, it stands to reason that property values may continue to appreciate this year. Although housebuilding may not reach government expectations, it is likely to see an uptick. While I remain cautious about significant reductions in short-term interest rates for the reasons outlined earlier, I also believe substantial hikes are unlikely.
What resonates most with me is the notion that homes serve as a cornerstone for the economy. They represent a vast store of wealth—approximately £9.1 trillion, according to a recent Savills study. This wealth will gradually be transferred to future generations, bolstering their financial stability and well-being.
Nonetheless, I share the concern over the challenges faced by young individuals lacking familial support. Furthermore, disparities in housing market performance across different regions, particularly outside London and the South East, are undeniably unjust. Yet, on a macroeconomic level, these large figures must be viewed as fundamentally positive.
This is Armchair Economics with Hamish McRae, a subscriber-exclusive newsletter from The i Paper. If you want to receive this directly in your inbox every week, you can sign up here.
