The Bank of England has a new headache – falling inflation

As Andrew Bailey and the rest of the Bank of England’s Monetary Policy Committee (MPC) gather on Threadneedle Street this week, you may think the mood would be buoyant.

Bailey, the Bank's Governor, has declared we are seeing “the beginning of a sign that a corner has been turned” on inflation, signalling that the Bank’s effort to contain runaway price rises are finally bearing fruit.

While far from job done, the Governor predicted that inflation “will fall quite rapidly this year” from spring onwards, bringing some relief for harried policymakers.

Yet falling inflation presents a new set of problems for the MPC as they prepare to meet to take their first interest rate decision of the year on Thursday.

For while inflation is now falling thanks to softening energy prices, there are fears that persistent strong wage growth could still keep it well above the Bank’s 2pc target.

The big questions facing policymakers is: how high do interest rates need to go to curb price rises? And how long do they need to stay there?

Alongside that, MPC members will be weighing the trade-off that higher rates for longer presents between tackling inflation and throttling growth.

Most experts believe inflation peaked at 11.1pc in October. It currently stands at 10.5pc, much lower than the 10.9pc the Bank had predicted at its last set of forecasts in November.

But minutes from December's interest rate decision suggest that most of the nine strong MPC believe the job is not yet done.

Many are worried about the risk that pay and prices could spiral out of control. This is one reason why they've raised interest rates nine times in a row, with next week expected to be the tenth. Financial markets and economists are betting on a half a percentage point increase to 4pc this week.

Another large raise is expected as the Bank's own survey suggests expectations for pay settlements for the year ahead have grown from an average of just under 5pc less than a year ago to 6.3pc in December - an upward trajectory that's showing no signs of reversing.

Meanwhile, official data show private sector pay growth – excluding bonuses – was a record 7.2pc in the three months to November.

Suren Thiru, director of economics at the ICAEW, says high inflation has led to unprecedented demands from workers.

“It's certainly the first time I've seen it. But it's also the first time we've seen this type of inflation shock. So we've seen multiple pay rises in one year, and we've also seen an increase in bosses targeting pay rises at certain parts of the workforce, especially lower paid staff.”

A shrinking talent pool has made it harder than ever for companies to find the right staff, even as the economic skies darken.

Money talks and with inflation running in double-digits many companies have been forced to raise pay multiple times over the last 12 months to hang on to staff and attract new employees.

Retail giants Curry's and Marks & Spencer both raised staff pay twice in 2022, handing out shopping vouchers and free food along the way.

Tight budgets and squeezed margins means others have turned to freebies. Vouchers, free stays in holiday homes and even a boxing ring have been offered as benefits to keep workers happy.

Even the Bank of England has joined in. There's been disquiet among the rank and file in Threadneedle Street, who threatened to strike over pay last year. A 4.5pc increase in the size of the pay pot was eventually shared among all, with pay scale increases, an extra day's holiday and even a dental plan brought in to sweeten the deal.

How long will these big pay demands last? The answer is probably longer than you might think.

Paul Hollingsworth, chief UK economist at BNP Paribas, says there's a reason why policymakers believe developments are “concerning”, with pay growth at the bottom feeding through to the rest of the economy.

Many worry that workers will continue to demand robust pay increases for several years as they play catch-up with price rises.

Sir Charlie Bean, the Bank's former chief economist, says: “I've always been concerned that wage growth would be a bit stickier than the Bank was projecting

The MPC has not placed enough weight on past price rises when thinking about future price growth, he argues.

“The Bank has a focus on inflation expectations,” he says. "But people want to protect their living standards. That's why I think the Bank is going to keep interest rates higher for longer just to squeeze that inflation out of the system.”

It is a tough message to sell to struggling households, who will see inflation falling but rates still rising.

A milder winter with stronger winds means inflation has fallen sharply since the Bank's last forecast in November.

Wholesale gas price futures are down nearly 40pc over the MPC's three year forecast period. Cornwall Insight, which has consistently provided the most accurate price cap predictions, says this suggests the average household energy bill could fall to £2,200 in the second half of this year. This is below the current cap of £2,500, and means it will not cost the Government anything from July.

All this suggests that inflation will be lower and growth higher than the Bank predicted just three months ago.

Deutsche Bank believes the Bank's economic forecasts will show “a dramatically improved economic outlook”, with a bigger drop in inflation and fewer people out of work.

Sanjay Raja, the Bank's chief UK economist, believes the Bank will forecast a recession that's half as long as they thought it could be in November. This means a year of economic decline instead of two and 350,000 fewer people out of work. He also believes inflation will “settle a little above zero in three years' time, balancing the effects of lower gas prices with stronger activity, wages, and a weaker supply outlook”.

Falling prices – albeit temporarily – will act as a much needed tax cut following the relentless run of price rises.

But as Alan Jope, the boss of Unilever, recently noted, peak inflation doesn't mean peak prices. He recently said there were €2.5bn (£2.2bn) of extra costs coming through the pipeline this calendar year.

A shrinking workforce also suggests that policymakers will revise up their estimate for where they believe unemployment will end up when the world gets back to normality. The Bank currently believes this is around 4.25pc, compared to the current 3.7pc rate.

Just a few months ago, markets were betting on close to 6pc. Today, most investors believe interest rates will barely get above 4pc before they have to come back down again. Some money men are betting on rate cuts before the end of this year.

Mr Hollingsworth at BNP Paribas thinks talk of cuts is premature, even if growth starts to falter.

“We think the MPC will keep rates at 4.25pc for the duration of 2024,” he predicts. “The cooling of the labour market and, in response, a weakening of wage growth and underlying inflationary pressure, are likely to take some time to materialise.”

In the meantime, Bailey and the MPC will be left in suspense as to whether the choices they have made are the right ones.