What’s next for inflation?

The final quarter of last year was marked by a sharp rally in the performance of bond and equity markets as investors came to suspect a “Goldilocks” scenario lay ahead — which would see economies avoiding recession but central banks relaxed enough over the trajectory of inflation to cut rates.

But such a Goldilocks scenario is the polar opposite of what both households and investors actually faced, whereby inflation moved upwards but as a result of demand-side factors such as people having greater earning power and so spending more, causing a rise in the general price level. 

Supply-side inflation dented the economic growth outlook, but factors such as energy price hikes are usually regarded as short term in nature, and so policymakers increased rates.

Higher interest rates generally reduce economic growth because they increase the incentives to save cash, but means rising costs for people with mortgages or other long-term debt, thereby reducing consumers’ disposable income. 

Although higher interest rates do not necessarily address the causes of supply-side inflation, even though they reduce demand in the economy, the view taken by policymakers was that supply-side inflation could turn into demand-side inflation, which can be longer term in nature if wage rises lead to persistently higher spending, prolonging inflation and leading to further wage demands — a phenomenon known as a wage-price spiral.

The euphoria in markets in the final quarter of 2023 gave way to a more tepid sentiment at the start of 2024, as inflation in the UK and the US seemed to be persisting and central bank language appeared to be retreating from the notion of rate cuts.

Stagnating growth

While UK inflation has fallen from above 10 per cent to the more recent 3.4 per cent, this has happened alongside a period where economic growth has stagnated.

Cutting interest rates is usually regarded as being a positive for economic growth, as it reduces the incentive to save and may reduce costs associated with debt.

But just as raising interest rates during a period of recession may seem to be counter-intuitive, so too is cutting rates at a time when inflation is still above the 2 per cent target. 

Cutting interest rates is usually regarded as being a positive for economic growth, as it reduces the incentive to save and may reduce costs associated with debt

Gavyn Davies, chair of Fulcrum Asset Management and a former chief economist at Goldman Sachs, says the near-term outlook for UK inflation is “much lower”, which will enable the Bank of England to cut rates if it wants to stimulate economic growth.