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Energy prices are directly responsible for around a third of the current bout of inflation. Food is also making a major contribution, such that the ‘non-core’ (food and energy) component accounts for roughly half of current inflation levels. Services inflation is running above longer-run averages, but to nothing like the same extent as energy, food, and goods inflation. What’s more, some of the increase in services prices stems directly from higher energy costs.  

The other main driver of inflation has been higher global goods prices. Trends in this area are inevitably complex. There is a basic energy and commodity cost dimension, which is now beginning to slowly moderate. Issues with global supply chains have also played a part, but pressure here too appears to be easing. Some high-profile components (such as second-hand car prices) are now moderating, but there is still a general stickiness in goods prices.

Inflation is forecast to fall in 2023 – albeit from very elevated levels – due to large energy price base effects. Nevertheless, we expect inflation will still exceed levels targeted by major central banks by the end of 2023, with US core price inflation (CPI) at 3.0%, eurozone inflation at 2.6%, and UK CPI at 4.3%.

Key inflation forecasts (%)

By the end of next year, we expect energy’s contribution to CPI to have fallen to 10% in the US and UK (from 20% and a third, respectively), and to have largely disappeared in the eurozone. Energy prices falling from a high base will be a necessary – but probably not sufficient – condition for inflation to return to close to target levels. 

For year-on-year inflation not to decline in 2023 would require an extraordinary price shock. While energy prices could well rise further over the coming years, it’s hard to believe price gains in 2023 will exceed those from this year. So, inflation should fall – but how far, and how quickly? 

In 2023 we expect tension between the disinflationary effects of recession and the inflationary effects of lagging cost pressures working their way through the system and tight labour markets. Forward-looking indicators tend to emphasise disinflationary pressures, while lagging and current indicators retain a more inflationary feel. 

A common feature of our US, eurozone and UK inflation outlooks is a degree of stickiness in core inflation in 2023 and 2024. Energy base effects will tend to reduce headline rates more rapidly than core measures, with the gap between the two narrowing sharply over the course of 2023.

We see subtly different factors at play in these regions. In the US, core CPI is expected to moderate from 6.3% at the end of 2022 to 3.2% by December 2023, and 2.1% by December 2024. The US dollar’s sustained strength is likely to weigh on core goods prices, while on the services side we expect prices to continue to increase (albeit less quickly than before) due to the shelter component.

The key factor likely to lead to sustained inflationary momentum in the US in 2023 is continued tightness in the labour market. In our view, for inflation to eventually get back toward 2% (the US Federal Reserve’s target), there needs to be a persistent situation in which there are fewer jobs than workers and somewhat fewer openings than unemployed workers. So far there has been no convincing evidence of wage pressures easing. Against a backdrop of a tight labour market, this will prevent core services inflation from slowing down significantly in 2023.

By contrast, wage pressures in the eurozone remain subdued. We view core inflation in this region less as a gauge of underlying inflation or a leading indicator and more a lagging reflection of energy prices. We expect some pick-up in wage inflation in the eurozone in the coming months, with the key question being whether this is one-off in nature or whether these pressures will persist. 

In the UK, demand indicators are more subdued than in the US and total hours worked remain 0.6% below pre-pandemic levels. The UK has its own idiosyncrasies – notably a sharp increase in inactivity during and after the pandemic, including a near-400,000, 17.5% increase in those classified as long-term sick. 

A key consideration is how permanent the reduction in UK labour supply is – the more permanent, the tighter the labour market and the higher that wage inflation would be expected to be. Conversely, to the extent that the move towards inactivity reverses in response to cost-of-living pressures and a turnaround in sickness trends, the higher the labour market slack in the UK. 

While central banks could be forgiven for having not foreseen the extent of the energy price shock in 2022, the experience and the criticism they have encountered suggest policymakers will be wary about easing monetary policy soon. To date, there has been no substantial progress in bringing down either inflation or wages. Until measures of inflation clearly reverse, we think it will be difficult for central banks not to continue to raise interest rates.

Although we forecast substantial declines in inflation in 2023, we still expect headline CPI rates to exceed 2% in the US, eurozone and UK at the end of next year. That doesn’t preclude interest rate cuts later on in the year, but our base case is still that rate cuts will not materialise until 2024.

The Bank of England ramped up its hawkish rhetoric in the aftermath of the UK government’s recent tax-cutting Growth Plan, warning of a ‘significant’ monetary policy response. Policymakers did step up the pace of tightening in November, hiking by 75 basis points to 3.0%, but also cast doubt on the market’s pricing of terminal rates of around 5.25%. Sterling’s weakness remains a potential problem for an open economy like the UK, with imports accounting for around 30% of the CPI basket. However, there have been some signs the currency is stabilising since the government’s fiscal policy U-turn and the changes of prime minister and chancellor. 

In short, we believe the Bank of England is unlikely to cut rates in 2023, even in the face of a deepening recession.

We believe that monetary policy tightening cycles have a little further to run, although there have already been some hints that policymakers are becoming less aggressive. We forecast the Fed Funds rate will climb to a terminal rate of 5.0% in mid-2023, slightly below the 5.1% peak that the market is pricing in. 

Finally, we expect the European Central Bank (ECB) to raise its depo rate to a peak of 2.25% by Q1 and remain at this level throughout 2023. This represents a significantly more dovish (and earlier) outlook for the peak in policy rates than the peak of around 3.0% in Q4 currently priced in by the markets.

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