Monthly UK Economic Outlook: October

Source: Decision Makers Panel Survey, BoE

Inflation fell more than expected in August

UK consumer price inflation (CPI) fell marginally from 6.8% year-on-year in July to 6.7% in August, but the big news was that core CPI inflation fell from 6.9% to 6.2% – well below the consensus expectation of 6.8%. This was thanks to slowdowns in both services and core goods price inflation. But inflation hasn’t gone away – services CPI inflation, an indicator of underlying domestic price pressures, is still elevated and above the 2000-19 average of 3.3%.

What’s the outlook from here? The headline rate of CPI inflation should continue to fall sharply, with energy’s contribution set to fall too. Household inflation expectations are also on a downwards trajectory and are now back to their long-term average.

Several factors should lead to further easing in services CPI. The recent increase in labour market slack should enable employers to restrict future wage increases, and falling energy costs for businesses should ease price pressures. Businesses are also planning smaller price rises ahead: according to the Decision Maker Panel survey, output prices were expected to rise by 4.4% year-on-year over the next 12 months in August, down from 5.5% in July. According to the latest forecasts from the Bank of England, the headline rate of CPI inflation will fall below 5.0% by the end of the year.

UK inflation and sub components (% change y/y)

Source: ONS

The labour market is beginning to cool

The labour market is clearly cooling, with unemployment above the Monetary Policy Committee’s (MPC’s) 4.1% forecast for Q3. Meanwhile, the three-month vacancy-to-unemployed ratio – seen by the BoE as the best indicator of labour-market tightness – was at 0.71 in July, down from a peak of 1.05 in August 2022.

What explains this? Businesses are pulling back on hiring amid rising borrowing costs and tighter budgets, with some considering redundancies. Surveys indicate worse is to come in the months ahead: potential redundancies in the first two weeks of September had more than doubled compared with a year ago.

As yet, there’s been no major impact on the pace of wage growth, with growth in average weekly earnings, excluding bonuses, remaining unchanged at an elevated 7.8% year-on-year. That said, the BoE downplayed the surging wage data in its September meeting, pointing to other wage indicators that show cooling wage pressures. This comes at a time of labour supply picking up, with the workforce expanding by 0.8% year-on-year in Q2.

Overall, rising borrowing costs and shrinking margins is starting to affect the labour market, and it’s likely that slack will continue to increase.

Total pay growth (% change y/y, 3m/3m)

Source: ONS

The tightening cycle may nearly be over

After 14 consecutive rate hikes, the BoE surprised the markets at its September meeting by pausing. This suggests borrowing costs have peaked.

The decision was heavily influenced by the lower-than-expected inflation data, but also labour market slack and weak PMIs. That said, the forward guidance was little changed from August: any higher-than-expected inflation readings will result in more hikes. In fact, rates look set to remain high until inflation is clearly heading toward 2% as the Bank did not mention any possibility of rate cuts. The bond market is pricing in a first rate cut for next September.

But the higher-for-longer scenario isn’t a certainty. If the resilience of the UK economy begins to fade, and inflation with it, the BoE will come under pressure to cut rates quickly.

Overnight Index Swap (OIS) forward curve

Source: Bank of England, OIS forward yield curve