Overview
Rising energy prices have forced a revision higher to the outlook for UK inflation, making it more difficult for the Bank of England to justify leaving interest rates unchanged. Capital Economics now expects consumer price inflation to climb from 2.9% in July to a peak of just above 4% early next year, up from its previous forecast of 3.8%.
Revised forecasts and growth data
Alongside the upward revision to its inflation projection, Capital Economics has raised its forecast for third-quarter growth to 0.4% quarter-on-quarter from a prior view of 0.2%. That adjustment follows official data showing real gross domestic product rose 0.4% month-on-month in July, a result that exceeded expectations. The research house noted some of the strength may be tied to longer-lasting factors such as AI-related activity rather than only temporary influences.
Central bank divergence
Policy moves elsewhere add pressure to the debate about UK policy direction. The European Central Bank raised interest rates by 25 basis points this week for the second time, and Capital Economics said the question for the U.S. Federal Reserve now appears to be when, rather than if, it will raise rates. At the same time, Capital Economics highlighted differences in the drivers of inflation across the major economies.
In its view, U.S. inflationary pressure is being driven more by strong demand linked to AI activity, a source that tends to be persistent and therefore typically requires higher rates to contain. By contrast, in the UK and the euro zone a greater share of inflationary pressure stems from a global supply shock that has lifted energy prices. Such shocks can sometimes be temporary, which makes the case for higher policy rates less straightforward in those regions.
How the UK compares with the euro zone
Capital Economics outlined three specific ways the UK differs from the euro zone, each with implications for the need to tighten monetary policy further:
- Policy starting point - At the start of the Iran war, UK interest rates were already restraining activity and inflation at 3.75% versus its neutral estimate of 3%, whereas euro zone rates of 2% were in line with its neutral estimate.
- Financial conditions - Despite the Bank of England holding rates at 3.75%, financial conditions in the UK have tightened more, with market interest rates rising 120 basis points since before the war compared with 100 basis points in the euro zone. That has contributed to larger mortgage rate rises in the UK.
- Labour market - The UK’s labour market is looser than the euro zone’s, which reduces the risk that higher energy inflation will feed through into wage growth.
Implications for Bank of England policy
These distinctions shape Capital Economics’ view that the Bank of England could diverge from other central banks. That does not preclude further tightening by the BoE, the research house said, but it added that a rate increase is unlikely at next Thursday’s policy meeting. Capital Economics also argued the risks to its forecast are one-sided and commented that the market expectation that the Bank will raise rates by more than the Fed from here - 100 basis points versus 85 basis points - and by as much as the ECB "seems odd to us."
Near-term data and the Bank’s dilemma
Capital Economics expects a flat unemployment rate of 4.9% in July and forecasts CPI inflation rising from 2.9% to 3% in August. It noted that data due next week "won't solve the Bank's rate dilemma," underscoring the uncertainty facing policymakers as they weigh the persistence of energy-driven inflation against domestic economic slack and tighter financial conditions.
This analysis reflects the forecasts and commentary provided by Capital Economics and the most recent reported macro data referenced above.