UK Inflation Drops to 2.3%: What It Means and What’s Next

Prices in the UK rose by 2.3% in the year to April 2024, marking the lowest rate since September 2021. However, this figure remains above the Bank of England’s 2% inflation target, leaving uncertainty about potential interest rate cuts in the Bank’s upcoming June meeting.

Understanding Inflation 

Inflation refers to the increase in prices over time. For instance, if a bottle of milk costs £1 and increases to £1.05 a year later, the annual inflation rate for milk is 5%. 

Measuring Inflation in the UK 

The UK's inflation rate is gauged by tracking the prices of hundreds of everyday items, such as food and fuel, through the Office for National Statistics (ONS). This "basket of goods" is frequently updated to reflect current shopping trends. For 2024, the basket included new items like vinyl records and air fryers, while items like hand sanitiser were removed. 

The ONS uses these price changes over the previous 12 months to calculate inflation, with the Consumer Prices Index (CPI) being the primary measure. CPI fell in April, largely due to decreasing gas and electricity prices following a drop in the energy cap. 

Persisting Price Increases 

Although inflation has significantly decreased from its peak of 11.1% in October 2022, prices are still rising, just at a slower rate. The persistent above-target inflation is partly due to high energy and food costs, as well as worker shortages, which increase labour costs. 

The surge in inflation in 2022 was driven by heightened demand for oil and gas post-Covid, and further exacerbated by Russia's invasion of Ukraine, which disrupted global energy supplies. 

The Role of Interest Rates in Managing Inflation 

The Bank of England aims to keep inflation at 2% by adjusting interest rates. When inflation exceeded this target, the Bank raised interest rates to 5.25%. Higher interest rates make borrowing more expensive, reducing spending and, consequently, slowing down price increases. However, this approach must be balanced, as it can also slow economic growth, affect homeowners with higher mortgage repayments, and deter business investments. 

Future Outlook for Inflation and Interest Rates 

In May, the Bank of England maintained the interest rate at 5.25% for the sixth consecutive time. Governor Andrew Bailey stated that more evidence of slowing price rises was needed but expressed optimism about the current trends. The Bank anticipates that inflation will fall close to the 2% target in the upcoming months. The next inflation figures will be released on 19 June, with an interest rate decision following on 20 June. 

Comparing Wages and Inflation 

Recent data shows that wages in the UK are rising faster than prices. Pay, excluding bonuses, increased by 6% in the first quarter of 2024 compared to the same period in the previous year. Adjusted for inflation, this represents a real pay increase of 1.9%. 

International Context 

The UK’s inflation rate of 2.3% is now below the eurozone’s rate of 2.6% in May. The European Central Bank (ECB) cut its main interest rate from 4% to 3.75% in June, marking the first reduction in five years. In the US, inflation fell to 3.4% in the year to April, and the Federal Reserve has maintained its key interest rate between 5.25% and 5.5% since July 2023. Analysts predict US interest rates may drop by the end of 2024. 

Leveraging Inflation with the FTSE 100 

The FTSE 100 index, comprising the 100 largest companies listed on the London Stock Exchange, can play a significant role in managing the impacts of inflation on investments. Here's how: 

1. Inflation-Resistant Sectors: 

• Consumer Staples: Companies like Unilever and Tesco provide essential goods and services that remain in demand regardless of inflation, offering stable revenues. 
• Energy and Commodities: Firms like BP and Rio Tinto often benefit from rising prices of oil and metals, which can outpace inflation. 

2. Dividend Yields: 

• Many FTSE 100 companies offer substantial dividend yields. During inflationary periods, these dividends can provide a steady income stream that helps offset the eroding purchasing power of money. 

3. Global Exposure: 

• A significant portion of revenue for FTSE 100 companies comes from overseas operations. This international exposure can act as a hedge against domestic inflation, as profits in foreign currencies can increase when converted back to a depreciating pound. 

4. Inflation-Linked Revenue: 

• Certain sectors, such as utilities and telecommunications, can pass increased costs onto consumers through higher prices. Companies in these sectors often have revenues linked to inflation, helping them maintain profitability. 

Key Considerations for Investors 

• Sector Selection: Focus on sectors that historically perform well during inflationary periods, such as energy, commodities, and consumer staples. 
• Dividend Stocks: High-dividend stocks can provide a reliable income stream that grows with inflation. 
• Global Diversification: Investing in companies with significant global operations can help mitigate the impact of local inflation. 

Conclusion 

While the drop in UK inflation to 2.3% is a positive sign, it remains above the Bank of England’s target. The upcoming decisions by the Bank will be crucial in determining whether interest rates will be adjusted to further control inflation. Meanwhile, the international landscape shows varied responses to inflation, reflecting different economic conditions and policy decisions across regions