The looming inflation threat facing Britain

Families have been tightening their budgets amid a cost of living squeeze. But there’s one thing many aren’t ready to give up just yet: their summer holiday.

Airlines including easyJet and British Airways are either back in profit or enjoying higher earnings amid the travel boom. This has driven up travel costs, forcing holidaymakers to pony up, even as the overall rate of inflation has eased to 6.8pc in the year to July.

Airfares rose by almost 30pc in July compared with a year ago, according to the Office for National Statistics (ONS), while ferry tickets are up 14.4pc.

Restaurant and hotel costs also saw near double-digit increases, pushing up the overall rate of services inflation to 7.4pc in the year to July 2023, up from 7.2pc in June.

These figures are a headache for the Bank of England, which already warned this month that services inflation was likely to remain “elevated” for the rest of this year.

Bank policymakers were expecting the rate to rise to 7.3pc, and average 7pc “through the second half of 2023”.

Meanwhile, private rents are rising at their highest pace since comparable records began amid strong demand from tenants, while insurance costs have also soared. Average car insurance premiums are up 50pc compared with a year ago. Claims usually require courtesy cars, which have become more expensive to hire, while the cost of repair materials such as paint and other tools has also shot up.

This is important because the Monetary Policy Committee (MPC) that sets interest rates has identified services inflation as one of the main indicators of persistent inflationary pressures. This is combined with tightness in the labour market and rampant wage growth.

These three factors will help to determine whether a fifteenth straight rate rise is warranted in September, with rates currently at 5.25pc. So far, all the signs are pointing to another rise.

Matthew Swannell, an economist at BNP Paribas, said services prices are likely to remain “sticky” in the coming months. 

“Services are not only running hot on an annual basis, but momentum is still running at a rate which is above a target-consistent pace,” he said. “This will only normalise as pay growth moves back towards rates consistent with inflation at target. This will probably be a relatively gradual process as the labour market loosens.”

Food prices are now the most powerful day to day symbol of inflation for most households. Energy bills have dropped back from their peaks, but food prices continue to rise.

Overall food prices in July were up 14.9pc on the year. This is down from a peak rate of more than 19pc in March, but remains painfully high.

The Resolution Foundation calculates the average family’s annual grocery bill has risen by £960 since 2019-20, which is more than the typical £910 rise in energy prices.

Some individual foods are spiralling at remarkable rates. Sugar costs almost 55pc more than it did a year ago. Olive oil, propelled in part by drought in Spain, is up more than 40pc. Eggs cost a quarter more now than they did a year ago.

But price rises are slowing for most items and a few even got cheaper between June and July.

Milk and butter cost less in July than the previous month as pressures in dairy markets ease. Potatoes also got cheaper on the month, as did cereals.

But hazards remain, warns Helen Dickinson, chief executive of the British Retail Consortium.

“Russia’s withdrawal from the Black Sea Grain Initiative and subsequent targeting of Ukrainian grain facilities, as well as rice export restrictions could put pressure on some global commodity prices, slowing the fall in food prices,” she says.

Looking at the bigger picture, while July’s drop in the headline inflation rate is welcome, it is unlikely to be repeated. Last month saw a big fall in the energy price cap to £2,074, from £2,500 over the winter.

Consultancy Cornwall Insight expects the price cap for a typical dual fuel, direct debit consumer to fall to £1,860 in October before rising to £1,958.81 next January. In other words, big drops in energy bills are behind us.

Rishi Sunak remains hopeful that he will meet his goal of halving inflation, insisting on Wednesday that “if we stick to the plan I’ve set out, we’ll get it done”.

However, the Institute for Fiscal Studies (IFS) think tank warned that the Prime Minister’s pledge could still be in “jeopardy” because of stubbornly high services prices as well as high so-called “core” inflation that strips out volatile price movements in food and energy.

“With only four months to go, it no longer seems at all clear that inflation at the end of the year will have fallen by enough to achieve it.”

But to use Sunak’s own words, there is also “light at the end of the tunnel”, with glimmers of hope coming from Britain’s manufacturers.

Factories’ costs spiked last year, surging at levels not seen since the ONS’s records began in the 1980s. The expense was rapidly passed on to customers – factory gate prices increased at their fastest since 1977.

But with the decline of energy bills and the end of many pandemic-era supply chain squeezes, costs are now falling.

The costs manufacturers face to produce goods fell 3.3pc in the year to July, led by falls in the cost of oil and petroleum products. Output prices, charged to customers, dropped 0.8pc.

Falls of this scale have not been seen since 2020.

Manufacturers’ customers are often other companies, whether that is factories where their products are further processed, or retailers.

It means there should be falling prices in the pipeline, which the ONS expects will reach the shop shelves around the end of the year.

There is also hope on the international front. Britain’s inflation has proven painfully persistent compared with other rich economies.

Prices are still rising faster in the UK than anywhere else in the G7. Germany’s inflation stands at 6.5pc, according to Eurostat, while Italy’s price rises are only a touch slower at 6.4pc and the US is seeing annual price rises of 3.2pc.

While there is not a direct relationship, the ONS notes that in terms of the peak in inflation and subsequent fall, the UK appears to be tracking around four months behind the US.

Although the situation is not identical – the US avoided Britain and Europe’s energy price surge – the UK’s tight jobs market has some similarities with that in the US, raising hopes that price pressures will indeed fade over time.

While prices at the factory gate may now be falling, the Bank of England’s inflation headache has far from gone away.

Sanjay Raja, chief UK economist at Deutsche Bank, says the current dilemma facing policymakers is not if they will raise interest rates, but by how much. 

There will be one more set of inflation and wage figures released before the MPC has to make its decision. Raja, like the Bank, believes inflation will inch back above 7pc in August “for two reasons”. He explains: “One, alcohol duties will see a hefty increase. And two, pump prices are likely to register a big gain after eight months of declines.”

Raja says if pay growth continues to climb at close to 8pc and services inflation remains above 7pc “the odds could tilt firmly to a half a point hike in September”.