Markets behave as if the UK inflation process has changed. The data suggest it has not.
Britain has been hit by one shock after another since 2020 — pandemic supply disruptions, the energy crisis after Russia’s invasion of Ukraine, the gilt market episode under Truss, and now renewed pressure from the Middle East. Each has tested the system in a different way. But the underlying inflation process appears largely unchanged.
That matters now. Inflation has been slow to fall, and the MPC is caught between a weakening labour market and a renewed energy shock that could push inflation back above 3.5%. The usual playbook — look through first-round energy effects, focus on second-round pressures — only works if the wage-price process is still intact.
The issue is simple. Are wages now more sensitive to expected inflation and less responsive to unemployment? And does services inflation respond more quickly and more fully to wage growth? If so, inflation will be harder to bring down, and policy will need to stay tighter for longer.
March’s data did not resolve the question. Headline CPI rose to 3.3%, services inflation to 4.5%, while core eased to 3.1%. That leaves the MPC in a familiar position: cutting is difficult with inflation still well above target, but raising rates is hard to justify as the labour market weakens. When it meets on 30 April, Bank Rate will likely remain at 3.75%. But the real issue is not this meeting. It is whether the dynamics that will determine rates in 2027 have shifted.
The graph below shows average weekly earnings, services inflation and inflation expectations since 2020. Wages and services prices rose sharply together through the inflation surge and fell together during the subsequent disinflation — a pattern that might look like a wage-price spiral in the making.
Source: ONS
It would be too simplistic to read it that way. Both wages and prices respond to the same underlying forces: inflation expectations, import prices and labour market slack. They move together not because one drives the other in a self-reinforcing loop, but because both are responding to the same underlying shocks. The question is whether those relationships have changed.
To address that, I estimate a simple two-equation system using data from 2001 to 2019 — that is, using data from before Covid.
Wage growth depends on its own past, unemployment and inflation expectations. The key result is that expected inflation passes through one for one into wages in the long run. The data confirm what standard theory predicts.
Services inflation depends on its own past, wage growth and import prices. Again, the long-run pass-through from wages to prices is complete. External shocks, captured by import prices, can temporarily drive a wedge, but do not alter the underlying relationship.
Taken together, the system is driven by three forces: inflation expectations, import prices and unemployment — the channel through which monetary policy operates. If that structure has changed since Covid, policy will need to reflect that change. If it has not, the implication is more reassuring: as the energy shock fades and the labour market softens, inflation pressure should ease without the need for significantly tighter policy.
Formal break tests are not well suited to deal with the surge in inflation volatility during 2020–25. Instead, I ask a simpler question: do the model’s out-of-sample forecasts provide unbiased predictions of the data?
Over the full 2020–25 period, the answer is broadly yes, implying that there is no evidence of a permanent structural break. But that leaves open an important question: did something change temporarily, even if it did not persist?
Looking more closely reveals something more interesting. While the forecasts for wages are unbiased predictors of future wages, the inflation forecasts break down in 2022 but perform well in every other year. The graph below shows the results of these tests over time.
Source: My calculations
The interpretation is straightforward. The 2022 surge was genuinely unusual, driven by energy prices and post-pandemic distortions that the historical relationships could not fully capture. But it reflects a temporary disruption, not a permanent shift in the inflation process. After that episode passed, the model estimated on pre-Covid data tracks the data well.
The implication is that the underlying process has not changed materially. Inflation now behaves much as it did before Covid. Wages still respond to unemployment, inflation expectations still anchor wage growth, and services inflation still reflects wage costs over time.
For inflation to fall sustainably, the labour market therefore needs to weaken somewhat further. That argues for keeping policy broadly unchanged for now rather than tightening further.
At the same time, the risks are clear. If expectations drift higher again, or if energy shocks trigger renewed price pressures, inflation will remain elevated.
The April decision is straightforward. The path to 2027 depends on how the labour market evolves.
