Why Rishi Sunak’s fate is in Putin’s hands

“We will halve inflation this year to ease the cost of living and give people financial security.”

Rishi Sunak’s solemn pledge to slash inflation, like some of his other promises, has been carefully calibrated to ensure the highest likelihood of success. As has been well noted, the Bank of England, among others, has broadly forecast inflation on the Consumer Prices Index (CPI) to fall from its current annual rate of 10.7 per cent to around 5.2 per cent across the fourth quarter of 2023.

Assuming inflation has a fairly steady downward trajectory over the next year, that implies a monthly CPI inflation rate of maybe somewhat less than 5.2 per cent – the average over October to December – in December alone. As a guess, it might be about 4 per cent: more than halved.

Even better news for the former chancellor and now prime minister (meaning he has been in charge of the economy for more than three years) is that the Bank sees, as a central forecast, inflation at around 1.4 per cent in the final months of 2024 (election year) and the prospect of zero inflation by the end of 2025.

Most other forecasters concur, though the Office for Budget Responsibility (OBR) is rather more cautious about the inflation outlook: “Inflation drops sharply over the course of next year, and is dragged below zero in the middle of the decade by falling energy and food prices before returning to its 2 per cent target in 2027.” Albeit the OBR focuses on wider trends in prices and costs, including for businesses.

There are solid reasons why Sunak should be able to deliver on his promise. The most powerful is a simple matter of statistics. From November 2021 to November 2022, domestic gas prices increased by 129 per cent and domestic electricity prices by 65 per cent, as we are all painfully aware.

Unless energy prices increase by the same amount again – which is unlikely – the energy price level should level out. Charges will stabilise and eventually fall. This, in turn, will push general inflation lower, given how important energy prices are throughout the economy.

Similar factors will see grocery inflation come down. A resumption in superconductor supplies from east Asia should similarly increase the supply of cars and consumer goods, again meaning better value for customers.

Obviously, much in the energy and food sectors (vegetable/cooking oils) depends on the progress of the war in Ukraine and sanctions on Russia. The evidence so far is that gas prices are responding well to the success of Ukrainian forces, but obviously this cannot be taken for granted. A revived Russian offensive or naval blockades could easily reverse recent falls in commodity prices, push inflation up globally, and wreck Sunak’s ambition.

Such a reversal of fortunes would probably come too quickly and be too sharp for the Bank of England to counter rising import costs by hiking interest rates. But in other respects, Sunak’s success depends to some degree on the Bank’s willingness to inflict an even deeper recession than expected. Inflation can always be brought down – but if it is at a cost of lost jobs and lower wages, it won’t feel like a triumph.

Which brings us to the question of wages. Thus far, private sector settlements running at around 5 per cent are accommodating inflation to some extent, but the same isn’t true of the traditional public sector.

A big worry for the Bank, and for the government, is if higher prices push wages up and then companies try to pass on the increase in their wage bills by raising prices (or taxes in the case of the public sector). This “wage-price spiral” rightly frightens policymakers, and if inflation does become embedded, then Sunak may be disappointed this time next year.

Confidence in the ability of the Bank and ministers to pre-empt this endemic, “home-grown” inflation will in turn affect sterling and import costs. Interest rates would have to go up steeply to neutralise the inflationary virus.

Last, Sunak has built-in wriggle room because of the vague phrasing of the promise. He doesn’t, for example, specify which of the many measures of inflation he will be judged on – though everyone assumes the CPI. He has also avoided defining whether he will be judged on an annual rate, a quarterly rate, or a monthly rate that is annualised.

Back in the 1970s and early 1980s, during previous battles against inflation, ministers tended to pick the index and the time period that best suited their political interests; indeed, entirely new indices were invented to massage the otherwise unflattering statistics.

Even with everything we know about that might happen, there are always “black swan” events. The Bank of England’s forecasts are actually presented as wide range of possibilities, fanning out as the time horizon recedes into the distance.

So, their central forecast of about 5.2 per cent inflation by the year end is highly contingent. There is in fact a 90 per cent chance that inflation might be somewhere between 7.8 per cent and 2 per cent, with a 10 per cent chance it might even be outside these upper and lower brackets.

If he’s unlucky, Sunak will be humiliated. Even if he is not, the pain of recession and past high inflation will still be a fresh and painful memory. According to the OBR: “Rising prices erode real wages and reduce living standards by 7 per cent in total over the two financial years to 2023-24 (wiping out the previous eight years’ growth), despite over £100bn of additional government support.”

Next year will feel better, but only in the way that it feels good to stop banging your head against a brick wall.