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Inflation set to drop to lowest level in two years as energy prices continue falling

Inflation is set to fall below five per cent for the first time in two years, but the job is far from over for the Bank of England.
Inflation is set to fall below five per cent for the first time in two years, but the job is far from over for the Bank of England.

Inflation is set to fall below five per cent for the first time in two years, new data is expected to show this week, ensuring that Prime Minister Rishi Sunak will almost certainly meet his target of halving inflation by the end of the year.

Figures out on Wednesday from the Office for National Statistics (ONS) are expected to show inflation falling to 4.8 per cent in October, down sharply from 6.7 per cent the month before.

The precipitous drop will mean inflation has halved since the beginning of the year, meaning Sunak will likely achieve one of his five core pledges that he set out shortly after becoming prime minister. In January the rate of inflation was 10.1 per cent.

The bulk of the drop will be driven by lower energy prices, which analysts at Goldman Sachs predicted will fall by nearly 17 per cent year-on-year.

This dramatic drop is largely driven by changes to Ofgem’s price cap. In October last year, energy bills were frozen at £2,500 after Russia’s invasion of Ukraine sent energy prices spiralling.

Since then prices have fallen fast. In October this year, Ofgem lowered the price cap to £1,834, still relatively high but significantly lower than last year.

Continued easing in food inflation is also likely to help ease inflationary pressures. The latest reading from the British Retail Consortium showed food inflation easing to 8.8 per cent in October, the lowest level since last summer.

The underlying rate of inflation is likely to ease in October as well. Core inflation – which strips out volatile components such as food and energy – will fall to 5.8 per cent, according to City estimates.

October’s fall will narrow the gap between inflation in the UK and the US and Eurozone, where it has fallen much faster. However, Ashley Webb UK economist at Capital Economics warned that “further falls (will) be more gradual” from here.

As the impact of external shocks on the UK economy eases, the Bank’s Monetary Policy Committee (MPC) is increasingly turning its attention to indicators of domestic inflationary persistence, particularly services inflation.

The Bank expects services inflation to remain near its current level of 6.9 per cent for the rest of the year. Sanjay Raja, chief UK economist at Deutsche Bank, likewise agreed that services inflation will be “a lot stickier” than the rest of the basket.

While some forecasts are predicting a sharper fall, an elevated level of services inflation is likely to encourage MPC members to leave rates at an elevated level for longer.

The Bank Rate currently stands at a post-financial crisis high of 5.25 per cent. Having been left on hold for two consecutive meetings, markets are increasingly certain that the MPC will not hike rates again this year.