When will UK inflation come down?

European inflation appears to have peaked as the energy price rises fall out of calculations. Meanwhile, in the US, which generates a lot of its own energy and is less affected by commodity price rises, inflation figures peaked several months ago.

Then we turn to the UK, where inflation has remained stubbornly high. Even though energy and house prices are lower, other price rises are keeping inflation at 10%. Brexit has of course has an impact, as a scarcity of workers (research from the Centre for European Reform and UK in a Changing Europe suggests there are 330,000 fewer workers in the UK due to Brexit) is causing wage demands and added trade frictions means importing goods is more costly.

Part of it is also down to interest rates, the structure of mortgages and the housing market. In the UK, most mortgages are renegotiated every 2-5 years. This means that a lot of borrowers will feel the impact of high-interest rates much sooner than those in the EU and US, where the average mortgage tends to be fixed for 18 and 30 years respectively.

As mortgage payments rise, rent increases too, so that homeowners can maintain their profit margins. If there was plenty of housing available, tenants would simply move, however, the supply of new homes has underperformed expectations, mostly due to Covid but also due to strict zoning laws. By some estimates, the UK housing market is tighter by 4 million homes.

Workers who can’t meet higher rent have to take advantage of the strong jobs market and ask for a raise. Whereas in the US wages are rising by about 4.6% per annum, in the UK the number has plateaued around 6%. In Europe it’s 5.10% but rising – which tells us that European inflation could also be sticky.

Over time, of course higher rates should curtail demand and cool the economy enough to bring inflation down. But for the time being consumer habits haven’t changed.

We expect UK inflation to come down to nearly 8% by summer, mostly due to year-on-year effects. However, evidence suggests that we have passed from the era of inflation driven by externalities to inflation driven by more internal factors.

In the UK and the EU, where labour markets are less flexible and many homes are rented (44% rentals in the UK and 64% in Germany, as opposed to 37% in the US), the inflation narrative may remain potent for some time. We would be surprised if UK inflation was below 5-6% by year’s end.

In the US, however, where the labour market is more flexible, we are already seeing price drops.

This should lead to a decoupling in both interest rate strategies and overall inflation figures. The US will probably lead developed markets out of inflation, while the UK and the EU will have to trail, perhaps even by a year before demand cools enough for prices to come convincingly down.

George Lagarias, Chief Investment Officer and James Rowlinson, Senior Investment Analyst