What does rising inflation mean for interest rates – and Rachel Reeves’s Budget?

Inflation is up again – prices are 3.6 per cent higher than a year ago, worse than the forecast 3.4 per cent – while the economy shrank by 0.1 per cent in May.

This news isn’t helping the government build a reputation for economic competence, and it adds to a rather depressing backdrop to the next Budget in late October, widely expected to be another with substantial tax rises. As we all know, elections tend to be won or lost on the economy.

Why is inflation up?

Partly for technical reasons related to how the consumer price index works: fuel and energy prices fell substantially around this time last year, pushing inflation down to the 2 per cent official target; and while they’re not rising much now, there is that arithmetic effect.

More substantially, and worryingly for ministers and the Bank of England, the figures suggest that core (or underlying) inflation – much of it attached to growth in wages – remains too strong for the Bank to be confident about trend inflation coming down markedly. That means an even slower downward path for interest rates.

For the chancellor, it seems some but not all of the increase in employers’ national insurance that came into force in April is being passed on in price rises, the rest being met by lower wage settlements and pruning of profit margins. The minimum wage increase has also increased labour costs. These have certainly given the opposition some ammunition.

As the governor, Andrew Bailey, sometimes remarks, the last yards of this marathon race to get inflation down are the hardest.

What will happen to interest rates?

It’s nuanced. The consensus seems to be that the Bank’s Monetary Policy Committee will cut rates at its meeting next month by another 0.25 percentage points, to 4 per cent – which the government would greet with enormous relief. Inflation trends aren’t bad enough to warrant postponing such a cut, which would in any case surprise and disappoint the City. However, inflation is still “sticky” and stubborn enough to mean that future cuts will be glacially slow in arriving. So mortgage holders and businesses won’t be as well off as they might be or as previously hoped.

Are these figures politically significant?

One month’s data rarely is, but Kemi Badenoch made the most of the mildly bad news at Prime Minister’s Questions, telling the prime minister that Britain now has the fastest rising prices among the G7 major economies. Aside from the prospective cut in interest rates in a few weeks, the short-term outlook is gloomy and that feeds through to the opinion polls.

The cost of living crisis is still on, and the next Budget will probably make things tougher for the middle classes. Labour’s rhetoric about “working people” and the chancellor’s boasts about putting more money in people’s pockets carry a little less credibility when inflation is poised to exceed four per cent later in the year and she seems so keen on cutting social security. More than that, there seems little short-term prospect of an improvement in the public finances or the wider economy. Heavy losses for Labour in next year’s local government, Scottish and Welsh elections look certain.

Are we in stagflation?

Arguable. It’s true that a variety of long-term factors, including Brexit and labour shortages, have conspired to reduce the ability of the UK economy to grow strongly without triggering inflationary pressures, especially in the labour market (which is why forthcoming jobs data will be closely examined by the Bank). However, inflation should gradually trend lower over the medium term, even if the prospects for growth will remain mixed – Trump’s tariffs being a major risk factor, notwithstanding the recent US-UK deal.

Reeves’ programme of structural reforms – planning, financial deregulation, air and rail projects, housing – will take years to make much impression on growth. By then some other party might well be in power to reap the dividends of her investments, but who ever thought politics was fair?