We believe the U.K.’s energy-driven inflation should prove largely transitory, but that healthy growth could produce more lasting pricing pressures.

High energy prices have attracted considerable attention from investors and policymakers this year. After dropping in 2020, demand rebounded and supply was unable to keep up. This led to record-breaking energy prices as Europe restocked after a cold winter. The U.K. has proven to be uniquely vulnerable, partly due to its poorly planned approach to decarbonization.

Since the beginning of the energy crisis, most central banks, including the Bank of England, assumed that higher energy prices were transitory and therefore took no action to tackle the seemingly short-term spike in headline inflation. U.K. natural gas futures contracts are currently trading 20% off the peak levels seen in October, so investor assumptions appear broadly in line with initial expectations. However, other factors could play an important role in this hiking cycle. Indeed, nearly every economic data release over the past few months has reinforced the view that U.K. growth is stronger than expected, suggesting that inflation across different parts of the economy could be more permanent.

The labor market is a key factor being monitored by the BoE—specifically the impact of the government’s decision to end its furlough program. So far, official payroll/employment data confirm limited disruption and continued healthy labor momentum. Overall migration levels declined during the pandemic due to the “Brexit effect” and global travel restrictions, which sharply curtailed cross-border movement and reinforced the tight labor market.

In addition, PMI prints as well as retail spending and overall consumer confidence are showing strength. If that continues into year-end, we should see more evidence of inflation feeding into wages, which in turn could mean more permanent inflationary pressures. Provided that incoming data remains broadly in line with BoE projections, the central bank may find it necessary to lift it bank rate in order to bring CPI back to its target level.