Has Inflation 'Turned A Corner'? Here's Why There's Economic Optimism At Last

Andrew Bailey, governor of the Bank of England, as interest rates were raised to 4% from 3.5%.

After months and even years of economic uncertainty – from the pandemic to the fall-out from the war in Ukraine and Liz Truss crashing the pound – is there light at the end of tunnel?

Here’s what’s behind the bout of optimism – whether it’s misplaced or not – that the cost of living crisis has passed.

Bank of England governor’s remarks

The Bank of England governor, Andrew Bailey struck an upbeat tone on Thursday. He said in a press conference that “we have seen the first signs that inflation has turned the corner”. Inflation currently stands at 10.5%.

Inflation was surging as a result of the easing of the pandemic. It meant the costs of goods and services became more expensive because of a number of factors – such as the scarcity of workers unwilling to do jobs they previously had, and pent-up demand from consumers.

While this was expected only to be temporary, Russia then invaded Ukraine last February. This sent energy prices spiralling given the world’s reliance and oil and gas from the region.

Bailey’s reason to be cheerful now? “This has a lot to do with energy prices,” He said. “Last year’s very large increases are beginning to drop out of the annual calculation.”

Why is the energy crisis easing?

Wholesale natural gas prices soared ten-fold during the first six months of the war in Ukraine, which fed through to the painfully high energy bills for homes and businesses. But this has fallen more than 60% from their August peak, meaning more mangeable bills should gradually feed through.

The fall is the result of a mild winter in Europe reducing demand for heating oil and natural gas, better storage and countries finding alternative suppliers to Russia. The easing has yet to filter through to families, but petrol prices have come down as oil prices have fallen.

So has inflation actually peaked?

The rate of inflation dipped for the second month in a row in December, offering evidence of the crisis peaking.

The fall to 10.5% in December from 10.7% in November showed further steady easing back from the painful 41-year high of 11.1% recorded in October.

But households and businesses are still facing eye-watering prices, with food price inflation hitting yet another 45-year high at 16.8% last month.

How about interest rates?

Raising and lowering interest rates is the blunt instrument used by central banks to control economies.

Hiking the “base” rate increases the cost of borrowing, making both credit and investment more expensive. The idea is to put the brakes on the economy and curb inflation.

Bringing rates down is an attempt to have the opposite effect – stimulate growth by making borrowing cheaper, and in turn, encourage investment.

On Thursday, the Bank of England decided to increase interest rates for the tenth time in a row, bringing its base rate to 4%, making it the highest level since the 2008 financial crisis.

UK interest rates.

Some believe the Bank may be near the end of its run of rate hikes with inflation abating and the UK expected to be in a recession this year – meaning cutting rates would be a more appropriate move.

The Bank signaled on Thursday the UK could be nearing peak interest rates, and may have already reached it. Decision makers said they might raise rates again, but only if they see evidence of more persistent inflationary pressures.

Bailey said his rate-setting committee had deliberately softened the language it used this time around as it no longer pledged to act “forcefully” to bring down inflation. But he added that it was “too soon to declare victory” over inflation just yet.

If inflation falls, will we avoid a recession?

It’s complicated and reflects the balancing act the Bank has to pull off. Bailey’s remit is to keep inflation at 2%. But taking the heat out of the economy by raising rates risks pushing the country into a recession. Job losses can often result from the policy.

A technical recession is defined by two successive quarters of falling economic output – measured by gross domestic product (GDP), which attempts to summarise all the activity of companies, governments and individuals in an economy in a single figure.

Some people argue the term “recession” is an unreliable indicator because people could be suffering all the effects of an economic downturn, such as long-term unemployment, but the data might not be officially say as much.

The UK economy declined by 0.3% in the third quarter of 2022 and would therefore enter a technical recession if a further fall is recorded for the final quarter of the year.

GDP actually grew unexpectedly in November by 0.1%, supported by – among other things – a strong showing by pubs and bars amid a boost from the winter World Cup in Qatar. It nevertheless represented a slowdown in growth after GDP increased by 0.5% in October.

Economists have suggested that the latest data makes it less clear whether the UK will have entered a recession at the end of last year.

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