Our seemingly benign economic state could quickly turn toxic

Since hitting a 16-year peak in early July, the two-year gilt yield – what the government pays to borrow money for 24 months – has fallen markedly, from 5.48pc to 4.92pc. Over recent weeks, even before the June data, traders have concluded UK inflation will drop sharply over the coming months.

At the start of this month, the Ofgem Energy Price Cap was lowered – which should reduce the average household utility bill from £2,500 to £2,074. As such, energy prices should drag down inflation as autumn approaches.

This reflects the fall in wholesale energy prices since last summer’s peak – as commodity markets went haywire after Russia invaded Ukraine. The spot price of European wholesale gas hit €333 per megawatt hour last August – more than 10-times today’s rate. As those “base effects” feed through, energy costs should fall sharply.

Another positive will be lower petrol and diesel prices. Supermarkets have lately been over-charging for fuel, according to the Competition and Markets Authority (CMA). During 2019, they made 4.6p on a litre of petrol, it says. That soared to 10.8p last year, with drivers over-paying supermarkets by a cool £900m in 2022.

If oil prices remain relatively stable, and ministers and the CMA face-down powerful retailers, then lower fuel prices, which already contributed to the drop in June’s headline number, should exert further downward pressure on broader inflation.

The June data pointed to some easing of grocery prices too. Food inflation has come down very slowly and remains high – falling from 19.1pc in April to 18.3pc in May and still at 17.9pc in June. But while the CMA says supermarkets and other large retailers need to display food prices more carefully, it found no proof of “price gouging” or profiteering.

On the contrary, the competition watchdog reckons food retailers’ profit margins fell from 3.2pc to 1.8pc last year. Having said that, given that energy and fuel prices are a major part of the food supply cost-base, cheaper energy should contain food prices.

There are, of course, various factors which could upend this benign scenario, causing this latest drop in inflation to stall or even reverse.

Wages are still rising rapidly – up 7.3pc in the three months to May, compared to the same period in 2022. Yet with various public sector strikes easing, and headline inflation down, the UK’s upward wage-price spiral could soon start to work in reverse. 

Yes, the labour market is an important part of the inflation conundrum but how will more rate rises help contain wage demands? Given the misery they impose on consumers, far from calming wage claims, higher rates could spark yet higher pay claims.

For me, the main determinant of inflation in the UK and across much of Europe over the coming months, relates to geopolitics. And, again, this has little to do with the MPC.

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