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The UK is struggling to subdue a persistent inflation problem — leaving it an outlier compared to other major economies. China has fallen into deflation, while in the US and the eurozone there are signs that price pressures are moderating.

In the two years since July 2021, consumer prices in Britain have climbed 17.6 per cent. Although the annual rate of increase slowed to 6.8 per cent in July, according to new figures, the improvement has been in the volatile parts of the index — food and energy.

The Bank of England has raised interest rates 14 times to a current level of 5.25 per cent, a 15-year high, yet most economists are surprised by the strength of prevailing price pressures. 

Hussain Mehdi, a strategist at HSBC Asset Management, said: “Overall, it’s clear that the extent of UK monetary policy tightening required will be more substantial than in the US and eurozone.”

Line chart of CPI inflation (%, year on year) showing Falling headline inflation masks no progress in improving underlying price pressures

Core UK inflation is stuck at 6.9 per cent, with the BoE’s favourite measure of domestic price pressures moving in the wrong direction. Annual services price inflation rose from 7.2 per cent in June to 7.4 per cent in July, the highest rate since 1992, with almost all categories getting more expensive, more quickly — especially rents, holidays, air fares and restaurants.

This week’s figures have made economists question how much further the Monetary Policy Committee is likely to raise rates, starting with its next meeting in September.

Before it gathers, there is another month of data to come. If this were to show that the latest hot inflationary data is just a blip, there might be a chance that interest rate rises will be paused or the BoE might signal that a September hike is probably its last.

On top of continued price pressures, annual wages rose to 8.2 per cent in the three months to June, representing the fastest increase since comparable records began in 2001, outside a period of data distortion in the Covid pandemic.

Naturally, many were happy that pay levels appear to be clawing back the hits from high inflation, but the BoE will worry that this could prompt companies to raise prices further.

This risks prolonging high inflation with marginal benefit to living standards, as raised costs would eat away the gains from higher salaries.

Weak retail sales data, meanwhile, did little to dampen concerns because the drop in spending on the high street in July was affected by the wet weather.

In financial markets, traders have taken the view that the data implies the BoE will not necessarily have to raise rates further than previously thought, but will maintain high borrowing costs for longer.

The yield on 10-year UK gilts — representing an expectation of the average interest rate over the next 10 years — rose to their highest level since 2008 on Thursday with the government paying a fixed-rate of over 4.7 per cent a year to borrow for the next decade.

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Krishna Guha, vice-chair of Evercore ISI, said that unlike in the US or Europe, these continued inflationary pressures were “unique” to the UK and the consequences will be ugly as the BoE takes further action.

“We think that preventing excessive real wage catch up will require higher unemployment and weaker growth, and possibly even a recession [in the UK],” he added.

Not everything is going wrong for the BoE, unlike earlier in the year when its forecast misses on inflation raised questions over its credibility.

Beyond wages, elements of the labour market have cooled and are beginning to generate conditions that are likely to bring price rises under control.

Unemployment has risen from 3.8 per cent a year ago to 4.2 per cent in the three months to June. Vacancies have fallen, bringing the number of available jobs for each person unemployed, on some measures, back to the 2019 average.

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According to some economists, indicators of a fully functioning labour market are a more important guide for future inflation than rapid wage rises.

“The labour market is continuing to loosen at a faster rate than the monetary policy expects,” said Samuel Tombs, chief UK economist at Pantheon Macroeconomics.

But as the jobs market unwinds, the BoE is left with a dilemma. Speaking about this week’s economic data, Benjamin Nabarro, Citi’s chief UK economist, said: “What is forward-looking is not hawkish and what is hawkish is not forward-looking.”

Pithy comments such as this do not help the MPC take a decision, however. If the committee members take the view that interest rates at 5.25 per cent are now “restrictive” and do not need to be raised further to bring down inflation sustainably, they run the risk of doing too little and appearing weak.

The danger is that inflation remains too high for too long, building further pressure for high pay awards and further price increases, embedding an inflationary psychology into society where large price rises are expected by everyone and they adapt to the new reality.

But if the committee takes the other route, as most economists expect, and raise rates further in September, and perhaps November, it risks too harsh an outcome and a deep downturn.

This could return inflation to 2 per cent, but go further causing unnecessary damage to economic growth and people’s lives.

Swati Dhingra, an MPC member who voted to hold rates at 5 per cent, said: “The risks of overtightening had continued to build, increasing the likelihood of output losses and volatility that would require sharper reversals of policy.”

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