UK QUARTERLY ECONOMIC OUTLOOK | Q1 2025
Inflation
3.5% later this year, with a risk of 4%
Headline inflation has already risen to 3% in January and will probably hit almost 4% by the middle of the year. However, not all inflation is created equally. Most of the rise in inflation this year will be driven by one-off factors or rising energy prices, neither of which the Monetary Policy Committee (MPC) can do much about. Domestically generated inflation will be much weaker than the headline numbers suggest.
There are three main factors that will drive inflation back to almost 4% this year, after its brief spell at the 2% target. First, some of the measures announced in the autumn budget, such as VAT on private schools, will directly add to inflation. For example, in January, education inflation spiked to 7.5%. Second, rising energy and fuel prices have already contributed 0.4 ppts to inflation since September and will add at least that much again over the next six months. Third, surveys suggest that firms are being much more aggressive in trying to pass on increases in employment costs than expected.
All these drivers of inflation reflect one-off increases in the price level rather than persistent drivers of domestic inflation. Assuming, of course, that there isn’t another round of tax increases or another surge in energy prices, inflation should start to come down in early 2026 as these factors fall out of the annual comparison. Given that growth is weak and the labour market is gradually cooling, there are reasons to believe the recent rise in services inflation should be slowly reversed over the course of this year.
Most of the rise in inflation this year will be driven by one-off factors or rising energy prices
That said, there are plenty of risks lurking about. Energy prices have already risen by 50% this year due to colder weather, but a re-escalation in geopolitical tensions could easily send energy prices soaring again. An increase in tariffs could also put upward pressure on prices. While the UK is not high on the target list for direct tariffs from President Trump, a more general increase in global trade protectionism would also push up prices. Finally, a stronger dollar or a weaker pound will also push up inflation in the UK as commodity imports become more expensive.
CPI inflation (% y/y)
