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Inflation Is Now 2%: Why Should You Care?

Jun 24, 2024 | Corporates, Investors, News

By Joseph Vambe

Inflation has long been a critical economic indicator, influencing everything from the cost of groceries to the interest rates on your mortgage. With the recent news that UK inflation has hit the Bank of England’s 2% target for the first time in nearly three years, it’s essential to understand what this means for you, your money, and the broader economy. This milestone is not just a number; it has real implications for your financial well-being, the political landscape, and the country’s economic recovery.

The 2% inflation rate is the Bank of England’s target, considered a sweet spot for economic stability. It indicates that prices are rising at a moderate and manageable pace. Hitting this target suggests that the UK economy is in a more controlled phase compared to the volatile inflation rates seen in recent years, which peaked at 11.1% in October 2022 due to the COVID-19 pandemic and the war in Ukraine. This significant drop from double-digit inflation is indeed noteworthy, but it’s essential to delve deeper into what this means in practical terms.

Firstly, it’s crucial to understand that a 2% inflation rate does not mean that prices are falling. It means that prices are increasing at a slower rate than before. For consumers, this can be somewhat of a relief as the purchasing power of money erodes less quickly. However, it does not equate to a reduction in the cost of living, which remains high compared to a few years ago. Food prices, for instance, are still 25% higher than at the beginning of 2022. The slight decrease in inflation is driven by a reduction in price rises for items like food and non-alcoholic beverages, and a slower increase in prices for recreation, culture, and household goods.

Petrol prices have seen a slight increase, while diesel prices have fallen marginally. This mixed bag of changes highlights that while the headline inflation figure is down, everyday expenses are still a concern for many households. Despite this moderation, millions of families are still grappling with the high cost of living, and the economic recovery is uneven. For many, the current financial environment continues to be challenging.

From a political perspective, the drop in inflation is being hailed by Prime Minister Rishi Sunak as “very good news.” Sunak, who is facing an uphill battle in the upcoming general election, argues that the Conservative government’s tough decisions have paid off, stabilising the economy and paving the way for potential tax cuts. The government claims that reaching the 2% target is a clear sign that their economic policies are working, despite the numerous challenges faced over the past few years.

However, the opposition Labour Party remains sceptical. Shadow Chancellor Rachel Reeves acknowledges that while the reduction in inflation is welcome, the pressures on household finances are still acute. She points out that prices are significantly higher than they were before the inflation surge, and many families are not feeling the benefits of this recent economic milestone. The cost of essential items remains high, and the impact of elevated prices over the past few years continues to strain household budgets.

Economists caution that while the 2% inflation target is a positive development, it is not necessarily indicative of a sustained downward trend. The Bank of England’s Monetary Policy Committee is expected to keep interest rates on hold at their current high of 5.25%. This decision is influenced by persistent inflationary pressures in the services sector, where prices are still rising faster than expected. Core inflation, which excludes volatile items like food and energy, remains relatively high at 3.5%.

The future path of inflation is uncertain. The Bank of England has predicted that inflation might rise again later this year, potentially reaching 2.6% in the final quarter. This projection is based on the expectation that the impact of falling energy prices, which have helped to bring down headline inflation, will wane. If core inflation does not decrease significantly, the overall inflation rate could climb again, posing further challenges for monetary policy and economic stability.

For households, the reality is that while the rate of price increases has slowed, the financial landscape remains difficult. Mortgage rates are still high, influenced by the Bank of England’s efforts to curb inflation. High interest rates have pushed up borrowing costs, impacting homeowners and potential buyers alike. Renters are also feeling the pinch, with average rents rising significantly over the past year. The high cost of living continues to erode disposable incomes, making it harder for families to make ends meet.

The general election on 4 July adds another layer of complexity to the economic narrative. The Conservatives are keen to highlight the achievement of reaching the 2% inflation target as evidence of their economic competence. However, Labour is likely to focus on the ongoing struggles faced by many households, arguing that the cost of living crisis is far from over. The political debate is set to intensify, with each party seeking to convince voters that they have the best plan to manage the economy and improve living standards.

In addition to the domestic implications, the UK’s inflation rate being lower than that of the US and Eurozone is noteworthy. It suggests that the UK is, in some respects, managing its economic challenges more effectively than some of its peers. However, this comparison also underscores the interconnectedness of global economies. The UK’s economic health is influenced by international factors such as global commodity prices and geopolitical events.

The potential implications for interest rates are significant. While the Bank of England is not expected to cut rates in the immediate future, the trajectory of inflation will be a key determinant of future monetary policy decisions. If inflation stabilises around the 2% target, there could be room for rate cuts later in the year, which would provide some relief to borrowers. However, if inflation begins to rise again, the Bank may be forced to maintain or even increase rates to prevent another surge in prices.

Ultimately, the news of hitting the 2% inflation target is a mixed bag. It offers some reassurance that the extreme volatility of recent years is being managed, but it does not signal an end to economic challenges. For consumers, the reality is that while price increases have slowed, the cost of living remains high, and financial pressures are still very real. The economic recovery is ongoing, and the road ahead is fraught with uncertainties.

In summary, the recent inflation figures are a significant milestone for the UK economy, but they are not a panacea. The impact on household finances, interest rates, and the political landscape will continue to evolve. As the country heads into the general election, the economic narrative will be a critical battleground, with each party seeking to convince voters that they have the best strategy to navigate these challenging times. The achievement of reaching the 2% inflation target is a step in the right direction, but it is only one part of a complex economic picture that will require careful management and robust policies to ensure sustained stability and growth.

The drop in May’s inflation figure was driven by a slight fall in prices for food and soft drinks, and slower price rises for recreation and culture and furniture and household goods. Prices for bread, cereals, vegetables, sugar, jam and chocolate all fell between April and May this year compared with a year ago. However, food prices overall are still 25% higher than at the beginning of 2022. Petrol prices also increased, rising by 0.7p per litre between April and May while diesel prices fell by 0.8p per litre. The inflation figure comes ahead of the Bank of England’s latest decision on UK interest rates this Thursday. The Bank is expected to hold the rate at 5.25% – a 16-year high – for the seventh meeting in a row. Markets have now also cut bets that the Bank of England will slash rates at its next opportunity in August. That is because price rises in the services sector remain high at 5.7% in the 12 months to May.

How quickly are prices rising in the UK? Inflation has fallen steadily since October 2022, when Russia’s invasion of Ukraine caused it to peak at 11.1% as food and fuel prices soared. But millions of households are still struggling with the cost of living. Even though inflation is falling, it does not mean the prices of goods and services overall are coming down, just that they are rising at a slower pace. The Bank of England has also put up interest rates to try to dampen down consumer demand, driving up mortgage rates and rents. Official figures on renting – also released on Wednesday – showed average rents paid to private landlords in the UK rose by 8.7% in the year to June. Meanwhile, even with the inflation rate falling, mortgage rates remain stubbornly high as lenders wait for the Bank of England’s next and subsequent moves on interest rates.

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