When will UK inflation return to the Bank of England’s target of 2% a year?

Forecasts of a rapid fall in UK inflation this year were over-optimistic. Wages and prices have responded sluggishly to inflation and food prices will continue to surge. Inflation is likely to remain high throughout 2023 and into 2024, reaching target by the end of 2024 or early 2025.

New data from the Office for National Statistics (ONS) show that the consumer price index (CPI), the most widely quoted measure of inflation, has remained at 8.7%, unchanged from April to May (see Figure 1).

Figure 1: UK consumer price inflation, 1989-2023

Source: ONS, via the ECO API
Note: This chart uses live data and will update automatically when new CPI figures are released each month. You can try the ECO API yourself using our Data Hub. Click here to find out more.

Most economists believe that inflation will eventually return to the Bank of England’s target of 2%. But they disagree over how long it is likely to take. Forecasts from the Bank itself as well as from the Office for Budget Responsibility (OBR) both predicted a rapid fall in inflation in 2023, leading to a return to the 2% target early in 2024.

Many commentators have also changed their views of when inflation will drop in light of recent events. Prior to the Russian invasion of Ukraine in February 2022, and the subsequent imposition of sanctions against Russia, it was thought that inflation would peak at about 6-7% in April 2022, then decline to 2% sometime in 2023. Clearly, things have changed.

What is driving inflation?

In the months following the Russian invasion, there was great uncertainty around how sanctions would affect global food and energy supplies. Natural gas prices peaked in August 2022 and the price of Brent crude oil a month earlier, with both falling back to 2021 levels by 2023. The increase in energy prices was the main driver of the surge in UK inflation in 2022 – peaking at 11% in October 2022.

Yet food prices have continued to rise in the UK and across the world. But as food and non-alcoholic beverages make up only a modest share of statistical agencies’ baskets of items (under 12% in the inflation index for the UK), food inflation is not the key to understanding the persistence of inflation overall.

The energy price shock that occurred in 2022 is now largely gone. Not only have energy prices stopped rising, but they have returned to 2021 levels. Nevertheless, this temporary shock has given rise to a much more persistent path of inflation. There are four main reasons for this.

Slow price responses

First, the prices of many products in the UK are slow to respond to changes in demand and costs. On average, looking across the prices that make up the CPI, the typical price lasts for 10-12 months (see Dixon and Tian, 2017).

So, for example, if you normally reset your prices every 12 months, and your price was last set in December 2021, you would not respond to the spike in energy prices until December 2022. Then, although the peak in energy prices was in mid-2022, the prices of goods and services are still responding to this peak into 2023.

Added to this is the fact that the prices of intermediate inputs – the goods and services used in the production process of other goods and services – are also responding sluggishly. As a result, the rapid rise in energy prices will take months to feed through into consumer prices as they gradually pass through the supply chain.

There is evidence of ‘state dependence’ too. Firms accelerate their price adjustment as inflation increases (see Davies and Dixon, forthcoming, 2023). This is reflected in the average age of prices declining from six months to five months in 2022, while the proportion of prices changing in the CPI data each month increased from 20% to 24% (with a particular rise in the proportion of price increases).

Even though prices became more flexible in 2022, there is still considerable inertia in prices. For example, if the average age of prices in a month is five months, this still means that on average, these prices will only change every nine months.

Consequently, the rigidity of prices means that the spike in energy prices will cause inflation to persist well beyond the initial shock. Essentially, the response of prices to the inflation shock is ‘flattened’ out over a long period.

With perfectly flexible prices, there would be an immediate response to the increase in energy prices, which would fade or go into reverse as energy prices start to fall. But with nominal rigidity, the price response is delayed and spread out over time. Further, the price increases become permanent – inflation may return to 2%, but the level of prices will remain permanently higher.

Slow wage responses

Second, wages have also responded slowly to the increase in inflation. If we compare average weekly earnings in February 2022 (£596) with February 2023 (£638), we can see that wages have increased by over 7% on average in this period. The figure is even higher in the private sector, where wages are paid by the firms supplying goods and services in the CPI.

So, even though (on average) earnings are not keeping up with inflation, they are still responding significantly to the increase in inflation. These wage rises will then feed through into firms’ costs and be an additional factor leading to price increases. This is particularly true in the services sector where wages are a large part of service providers’ costs.

But again, wages are reacting with a delay. So, we can expect them to continue to increase into 2023. As with prices, we can see that the impact of the spike in inflation in 2022 is casting a long shadow on wages as they attempt to catch up many months later.

The response of wages to inflation is greater because there are currently many unfilled vacancies. This is referred to by economists as a ‘tight’ labour market. In the UK, the overall unemployment rate also remains historically low (see Figure 2).

Figure 2: UK unemployment, 16+, 1971-2023

Source: ONS, via the ECO API
Note: This chart uses live data and will update automatically when new unemployment figures are released each month. You can try the ECO API yourself using our Data Hub. Click here to find out more.

Another crucial factor in the wages story is the indexation of the national living wage (NLW), previously known as the minimum wage. This is adjusted annually in April and is usually chosen to increase in line with CPI inflation in the previous year.

In April 2023, the NLW was increased by 9.7%, reflecting inflation in 2022. While it currently only directly applies to about 2% of employees, most low-paid job rates are closely related to it and tend to move with it. Here again, we have a delayed response of wages in the low-pay range to inflation, which will then feed through into increased prices in 2023.

We can see that the slow responses of both prices and wages tend to mean that the impact of inflation is more spread out and persistent. The two together indicate that we have a ‘wage-price spiral’, a feedback mechanism whereby increasing prices generate increasing wages, which in turn lead to higher prices. This can lengthen the inflationary effect even more.

Food inflation

The third reason for the persistence of inflation is that there are enduring inflationary pressures other than energy, in particular food inflation. Food price inflation has not ended yet and its effect will persist long after it does, for the reasons outlined in the first two points.

The causes of food inflation are harder to pin down, reflecting global factors such as weather. But given that Belarus, Russia and Ukraine all play major roles in food production – particularly in terms of grain and fertiliser – the effects of the war and sanctions have reduced supply.

Fertiliser prices doubled and then tripled in 2022. Although they have fallen more recently, they are still well above their 2020 levels. Higher fertiliser prices also affect the costs of food production around the world.

Monetary policy

The final piece of the puzzle of inflationary persistence is monetary policy and its influence on expectations. The pricing decisions made by firms are both backward- and forward-looking – to some extent they ‘catch up’ with past increases in costs, while at the same time looking forward to future costs and demand.

In addition, firms will take a sideways look at what their competitors are doing on prices. So, expectations of inflation are also a crucial determinant of how inflation turns out. There is a ‘self-fulfilling’ element to pricing behaviour. If firms believe that there is going to be more (less) inflation, then they raise their prices by more (or less) , which then results in more (less) inflation.

This is where monetary policy and the Bank of England’s decisions come into play. If firms believe that the Bank is going to get inflation back to target quickly (the beginning of 2024, for example), then this will moderate their current price increases.

But if the Bank of England loses credibility and firms don’t believe that it will be able to bring inflation down quickly, then they will tend to raise prices more, leading to higher inflation.

If it does lose credibility, the only way that the Bank of England can limit the increase in wages and prices is to reduce consumer demand and increase unemployment. The Bank achieves this by raising interest rates, which is very unpopular as it puts up people’s mortgage and loan repayments.

Although interest rates are low by historic standards and still well below inflation, households and firms have been used to over a decade of near zero rates since the global financial crisis of 2007-09.

History teaches us that, in the past, inflation at current levels has not tended to go away without pain. For example, in the UK, the deep recessions of 1980-81 and 1990-91 were both part of the process of bringing inflation down.

When might inflation fall?

So, how soon can we expect inflation to get back to 2%? It is clear that the forecasts from late 2022 by the Bank of England and the OBR were too optimistic. They forecast a rapid fall in inflation during 2023 that has not yet shown up in the first two quarters. They also expected that inflation would be back to target in the first half of 2024.

The National Institute for Economic and Social Research (NIESR) has forecast inflation to be more persistent. In its March 2023 Economic Outlook, it predicts that inflation in 2024 will still be well above target (around 4-5%) only falling back to 2% in 2025. This seems to be a much more realistic assessment.

Even the Bank of England’s latest Monetary Policy Report from May 2023 has put back the date by which inflation will reach target to late 2024. The OBR was still sticking to an unrealistic decline in CPI inflation in its March 2023 Economic and Fiscal Outlook, with inflation being below the 2% target for most of 2024 and becoming negative in 2025.

Of course, inflation falling to 2% by early 2025 assumes that there are no new big inflationary shocks. One risk that would cause even higher levels of inflation would be an intensified trade war between China and the United States.

Since China produces almost 30% of world manufactured goods, if this supply were cut off from Europe and the UK, the prices of many consumer goods would increase by a large amount and the inflationary shock would be bigger than seen in 2022. We should hope that this will not happen, and that Sino-American relations will improve to avoid the high costs of such a conflict, particularly in the run-up to US elections in late 2024. Another possible inflationary shock might come from an escalation of Russia’s war in Ukraine leading to a direct conflict between Russia and NATO.