Time to prepare for the return of inflation

One of the unintended consequences of the recent Budget is the dark cloud it has cast over the macro landscape. Bank of England governor Andrew Bailey could not have been clearer when he declared last week that the policies announced by Rachel Reeves are expected to raise inflation, while companies, particularly those in the people-intensive service sectors, have been vocal about the pressure they will now be under to put prices up to soften the blow of a £25bn Budget hit. Could the government’s own bellows now fuel inflation all over again, putting rate cuts in jeopardy too?

This year consumer price inflation has fallen steadily to just 1.7 per cent in September, a drop which was below the rate expected by the Bank of England. The steady downward path meant the Bank had no hesitation in making its second rate cut a week ago, and it delivered the 0.25 basis point reduction as expected, taking the base rate from 5 to 4.75 per cent. But the course ahead has now changed and a third end-of-year cut has been ruled out by most market watchers in the face of new emerging inflationary pressures.

There are three reasons why it now looks likely that a hiatus is emerging in the inflation battle. The first is the risk that companies will choose to pass on the new higher payroll costs to consumers. Peel Hunt calculates that the combined hit of increases in the national living wage and in the employer NIC rate is equivalent to a 10 per cent wage rise from next April, and says businesses with lower margins have more limited mitigation opportunities.

BT, Fuller, Smith & Turner, Howdens, Sainsbury’s and JD Wetherspoon are among those who have issued stark warnings that one method of recouping the cost of hikes to employer national insurance and the national living wage is through price rises. Their suppliers will also be feeling the brunt of the changes. Other options include absorbing the hikes and cutting margins; job cuts; and awarding lower pay rises to employees – a measure that could be tricky for employers fighting to retain and attract staff. Rob Morgan at Charles Stanley, however, anticipates we will see more price increases than lower corporate margins.

Other sectors will be affected in different ways. Panmure Liberum notes that the burden of higher NI on construction companies such as Galliford Try and Costain can be passed back to the government, as contracts are usually based on businesses’ actual costs. By contrast, equipment rental company Babcock, which has just over £1bn of salary costs, has less leeway. UKHospitality has warned the Budget measures will increase the cost of each full-time employee in the sector by at least £2,500.

A second reason is that wage growth is still strong and while the labour market appears to have loosened slightly, no one quite trusts the data. Private sector regular pay has eased to 4.8 per cent – too high for the Bank to be confident it will fall to a less risky 2 to 3 per cent year on year, while above-inflation rises in the public sector will nudge up average weekly earnings estimates. They could also strengthen workers’ resolve to fight for higher pay awards in the private sector.

A third inflationary pressure ensuing from Budget proposals is that of higher spending for hospitals and schools. The Office for Budget Responsibility says heavy front-loading of spending will be inflationary for not just workers but also the materials and goods being purchased. This is one reason why the office has upped its own inflation predictions and estimates the Budget will add 0.5 per cent to CPI next year.

What it all means is that expectations around rate cuts have changed, with previous predictions of a rate of 4 per cent in the first half of next year now jettisoned. Analysts suspect the US election results will also encourage caution at the Bank given the potential for new inflationary pressures to emerge from a tariff war and a fall in sterling.

Bank of America analysts think the Budget has increased the odds of the Bank moving slowly on wage cuts, and potentially stopping short of where they previously expected. Capital Economics has raised its core CPI forecast; in 2026 it projects CPI will be at 2.2 per cent, compared to 2 before the Budget. Pantheon Macroeconomics now expects the MPC to ease once a quarter rather than at every meeting. The verdict at Berenberg is that “Reeves has confiscated doves’ ammunition” and the argument for looser policy is harder to make. It therefore sees bank rate getting down to a terminal rate of 4.25 per cent in the second quarter of next year.