Why UK Inflation Is So High And What It Means For Interest Rates

(MENAFN- Gulf Times) While a post-pandemic burst of inflation has abated across much of the developed world, the UK is still stuck with the highest price growth among big Western economies.
Granted, consumer price inflation is now well below where it was in late 2022, when it maxed out at 11.1%. That's after the Bank of England aggressively ramped up benchmark interest rates from almost zero in late 2021 to 5.25% in 2023, sucking money out of the economy by hammering the purchasing power of borrowers.
Yet inflation is back again, with CPI reaching 3.8% in July and August, its highest in more than 1-1/2 years and well above the BoE's 2% target. The bank has responded by maintaining its key rate steady at 4%, prolonging the economic pain for households already suffering from a historic squeeze in living standards.
Here's why it's proving so hard to get the cost of items ranging from beef to fuel back under control.
What's happened to UK inflation?
Britain's inflation rate surged when economies emerged from the Covid-19 pandemic, as people spent money they'd saved during lockdowns and companies struggled to meet the resulting demand jump amid supply chain disruptions. What's more, energy prices shot up following Russia's invasion of Ukraine in February 2022.
Higher interest rates have combined with falling energy costs to bring inflation down, but UK CPI has settled above the levels seen across much of continental Europe. August inflation was 0.9% in France and 2.2% in Germany.
What's the reason for the UK's higher inflation?
The bounce back from a brief low of 1.7% in September 2024 has been driven by a rise in household utility bills, particularly energy and, more recently, food.
The UK is more reliant than most other major economies on imported gas for its energy needs. UK gas prices surged in 2022 and haven't returned to pre-pandemic levels. Gas determines electricity prices more than 90% of the time because, under the UK's“marginal pricing” system, the most expensive source of energy determines the final price.
Energy isn't the whole story. Labour shortages after the pandemic drove up wage growth, and rail and public-sector unions went on strike for better pay during and after the inflation shock.
Regular annual pay growth was 4.8% in the three months through July - above the 3-3.5% level that the BoE judges to be consistent with a 2% inflation target and 1-1.5% productivity growth. It is easing, however.
The government has also contributed to price pressures by increasing the National Living Wage - the minimum that employers must pay staff who are at least 21 years old - by 9.7%, 9.8% and 6.7% consecutively over the past three years. In April, the government brought in a £26bn ($35bn) payroll tax, which employers have been passing on to customers by raising prices.
Why does high inflation matter?
At the most basic level, it increases the cost of living and erodes consumers' spending power - especially for those whose wage growth fails to keep pace with the higher prices.
High inflation punishes those on low incomes more as a larger share of their spending goes toward essential items. Food and non-alcoholic drink prices were up 5.1% in August compared with a year earlier, official figures showed. Food prices alone have increased by close to 40% since the onset of the pandemic in early 2020.
Also, Britons tend to refinance their mortgages more frequently than their peers in the US and continental Europe, so many households are exposed to the higher interest rates imposed by the BoE to get inflation back under control.
UK borrowing costs have been cut five times to 4% from a peak of 5.25%, but are coming down more slowly than in the euro zone, where there have been eight cuts to 2% from 4%. Working-age people often face the biggest squeeze as older generations tend to own their house outright and receive pension payouts linked to inflation.
What role has Brexit played in the UK's stubborn inflation?
Many economists say the UK's exit from the European Union has its fingerprints on the inflation troubles.
Research by the London School of Economics suggested that a third of UK food price inflation from the end of 2019 to March 2023 was caused by Brexit because extra border costs added £7bn to grocery bills.
BoE Monetary Policy Committee member Catherine Mann warned the newly erected trade barriers made the UK“unique.” The Labour government has struck an agreement with the EU to reduce border frictions for food, but the bigger goal is a broader deal for all goods.
What else might be driving UK inflation?
Britain's productivity has declined in recent years, and now lags that of most other leading industrialised nations. A workforce that's less productive produces fewer goods and services, at a higher cost per unit, and this limits the economy's ability to grow without stoking inflation.
In the second quarter of 2025, productivity growth as measured by output per worker was negative: There was a decline of 1% compared with the same quarter a year earlier, according to the Office for National Statistics.
The“speed limit” of an economy, above which growth becomes inflationary, is determined by productivity and labour supply. High levels of migration since 2010 have propped up the UK growth rate, concealing the dismal productivity performance. A long-running dearth of business and government investment has been blamed for the paltry productivity growth since the 2008 financial crisis.
Will UK inflation fall soon?
Rising food prices have emerged as the latest obstacle to lower inflation. Beef, orange juice and chocolate have seen big increases. Fuel costs have also jumped, lifted by the price of oil.
The BoE is alert to even temporary price spikes as households - sensitised over recent years to the damage to living standards inflation can cause - try to boost their spending power with higher pay demands.
Bank officials have said they believe higher interest rates are working and inflation will be back at 2% in early 2026. But the immediate hump in price growth is making them nervous.
Inflation is now one of the biggest concerns among the public, with food inflation expected to rise to 6% by the end of the year,” said Helen Dickinson, chief executive of the British Retail Consortium.
The UK jobs market has shown clear signs of cooling, which may reduce upward pressure on wages. A BoE survey of employers found that wage growth will be around 3.5% by the end of 2025. US President Donald Trump's trade war may also help the disinflation process in the UK as exporters such as China reroute shipments to lower-tariff countries like Britain.
When will the BoE cut interest rates, and how far?
The BoE refuses to give an official estimate for the“terminal rate,” where borrowing costs will naturally settle if the economy is operating at full capacity and inflation remains at 2%.
Most economists believe it is between 3% and 3.5%. Alan Taylor, an external member of the BoE's Monetary Policy Committee, said he believes rates will settle at around 2.75%. Compared with the decade after the financial crisis, when rates were around 0.5%, that seems high. Before 2008, however, rates were rarely lower than 4.5%.
By late September, with UK inflation looking stickier than previously thought, investors had reined in their expectations for imminent interest rate cuts, and markets were pricing in little likelihood of a cut in November, and only a small chance of one in December.

MENAFN25092025000067011011ID1110111885