UK inflation has fallen below 10 percent: How should businesses approach the next phase?

June 13, 2023UK inflation fell to single digits in April 2023. However, businesses are still facing acute pressures and the next stage in the pricing cycle brings its own complications. A lower rate of inflation still means that costs and prices continue to rise, albeit at a more gradual pace. Furthermore, these new circumstances involve new uncertainty, with likely volatile and varied cost and price increases across different products and sectors. Many UK companies have been reluctant to fully adjust their pricing to reflect the recent steep rises in costs—for good reasons. Now, it is crucial to recognize that aspects of the higher inflation environment may be here to stay. Businesses need to prepare for the next phase of inflation by embedding agile pricing and competitive practices.

Price rises continue to challenge

After 40-year record high inflation rates in the double digits, UK consumer price inflation appears to be finally abating. Annual CPI inflation in April 2023 came in at 8.7%¹, and most forecasts expect price increases to moderate further, to around 3-5% by the fourth quarter of 2023².

According to the Office for National Statistics, three quarters of the 10.4% CPI inflation in February 2022 was attributable to energy or energy-intensive items³. With full-year natural gas prices down by more than 80% from their August 2022 peak⁴, price increases caused by the spike in energy costs should soon be over and may even reverse. For example, Ofgem has already announced its energy price cap for July 2023 at a level which is 17% lower than the cap set by the government’s Energy Price Guarantee in April 2023⁵. A similar pattern is present in other commodity prices, which spiked after Russia’s invasion of Ukraine, but most of which have since moderated.

This development provides some respite for both businesses and households, suggesting that the worst may be behind us. However, it is essential to note that lower inflation does not imply a reduction in costs or prices. It simply means that prices will continue to rise at a slower rate—a rate that may still be considerably above historical averages or the Bank of England’s target rate of 2%, at least in the next 12 to 24 months.

For example, the Bank of England’s median projection is for 3.7% CPI inflation in 2024, with a 90% probability that it will be between 1% and 7%. McKinsey’s modelling in partnership with Oxford Economics suggests a similarly wide range of scenarios, with a headline inflation rate ranging from a low of 0% to a high of 8% across the four quarters in 2024⁶. Households’, businesses’, and financial markets’ inflation expectations also remain elevated⁷. Businesses should therefore be prepared for potentially higher-for-longer, but uncertain, inflation.

So, the path towards more moderate inflation is not going to be immediate or certain. Nor is it likely to be uniform or smooth.

Price changes are likely to be volatile and vary widely

Navigating a post-peak inflation landscape requires an understanding of the inherent uncertainties that could follow. Price changes are unlikely to be uniform across all products and sectors, adding complexity to the decision-making process. Different industries will experience varying levels of inflation, and individual products within those sectors will be affected differently. Three phenomena make anticipating price dynamics particularly challenging: volatility, lags, and dispersion.

Let’s start with volatility. A large proportion of UK’s high inflation—around 70% in the last 12 months—has been attributable to import-intensive goods and services⁸. This means that the large swings in global commodity prices caused by both COVID-19-related supply chain bottlenecks and the war in Ukraine also show up in producer and consumer costs. Even outside of periods of large economic shocks, it is typical for commodity prices to exhibit significant ups and downs; and some of that volatility is passed through to domestic prices.

However, the process of price pass-through is not perfect or immediate. For example, McKinsey’s modelling of UK food prices suggests that changes in global commodity costs impact consumer prices with a roughly 9-month lag, and that not all changes—at either extreme of large increases or large decreases—are fully reflected in prices on supermarket shelves. Putting all these dynamics together creates a picture of roller-coaster-like inflation, rather than smooth transitions between higher and lower inflation periods.

For example, by the time lower energy prices feed through to the cost of processed food, globally the cost of sugar may be going up again, pushing the prices in a different direction in a few months’ time. Indeed, this volatility is one of the reasons why central banks tend to look at so called “core” inflation—a rate that excludes the impact of energy and food prices.

Another key phenomenon is the very wide dispersion of price changes in a typical month. This is true even when inflation is relatively low or stable but becomes particularly pronounced when inflation is changing rapidly. Exhibit 1 illustrates this by plotting the annualized price changes of the 219 items in the consumer price index consumption basket in the month of April in each of the years from 2016 to 2023.

1

Take April 2016, when inflation was low—at 0.3%—and relatively stable. Price changes were, nevertheless, widely distributed. The prices of IT accessories and small electric appliances reduced by more than 20% from the previous year. Some items’ prices did in fact go up by around the same amount as general inflation; these included new cars and some dairy products but were in the minority. At the other extreme, some prices increased by more than 10%, including, for example, wireless telecom services and motor vehicle insurance.

In April 2020, inflation was also low but rapidly decreasing, having gone down from 1.5% in March to 0.8% in April. The range of price changes was just as wide, but with a few more items with large weights in the consumer basket pulling the average down. For example, the prices of petrol, diesel, and natural gas all declined by more than 12% relative to the previous April. Low overall inflation did not, however, mean that no prices experienced large increases. Indeed, the price of clothing accessories went up by 18% and processed fish and seafood by 13% on an annualized basis. In the most recent period of rapidly increasing (2022), and then decreasing (2023), inflation, the dispersion of price changes has been even wider. A similarly wide range of experiences applies to labour cost increases in different sectors (Exhibit 2). For example, in the year ending in March 2023, average weekly earnings rose by 0.4% in the real estate sector, compared to a 9.4% increase in professional services. This was, in part, a reflection of the different supply and demand dynamics playing out in different parts of the UK’s labour market.

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In practice, this type of volatility and differences mean that individual businesses can glean limited information from aggregate inflation trends. Understanding and reacting to each sector’s specific cost and pricing dynamics becomes critical to maintaining margins and competing for market share. Yet, as we see below, it seems that many UK companies have not yet operationalized such practices.

Many businesses have been slow to adapt

The steep rise in costs associated with inflation has posed significant challenges for businesses. Many have been hesitant to pass on the full burden of increased costs to their customers, fearing potential negative repercussions such as reduced demand, loss of market share, or impaired customer relationships. Consequently, some companies have absorbed a portion of the cost increases, opting for slimmer profit margins in the short term.

For example, in February 2023, 23% of all businesses said they had not passed any input cost increases on to customers in the previous 6 months. Only 6% of businesses said they had passed through more than 75% of price increases⁹. While such survey results need to be interpreted with care, there is other evidence to suggest that price pass-through has been incomplete, especially early in the inflation cycle¹⁰. Considering that, year-on-year, manufacturers’ materials costs had gone up, on average, by 15%¹¹ and overall labour costs by around 6%¹², this implies a very significant squeeze on companies’ margins.

One of the reasons why consumer price changes tend to lag producer cost changes is lack of flexibility in when companies re-price their products or services. In Bank of England surveys in February to April 2023, 41% of businesses said that they only changed prices at fixed intervals (e.g., once a year or once a quarter). Having said that, businesses are adapting: the same survey also found that, more recently, firms appear to have become more responsive to changes in general inflation¹³.

While moderating price increases to customers may have been a reasonable approach during the peak of inflation, decision makers now need to consider the possibility that the new inflationary environment might persist. Even if the rate of cost and price rises abates, it may remain considerably higher than historical averages or the Bank of England’s 2% target. As such, businesses need to reevaluate their pricing approaches and consider implementing necessary adjustments to safeguard their long-term viability.

Now is the time to overhaul pricing practices

To thrive in an environment characterized by potentially higher-for-longer, or at least volatile, inflation, businesses will need to proactively prepare themselves. A lot can be learned from organizations that shifted to a completely new way of pricing as the reality of higher inflation started to dawn. Not everything will be the same as inflation rates come down—but the principles of good pricing practice can, by definition, be adapted to suit most developments.

These practices involve a comprehensive assessment of both cost and price dynamics. Evaluating supply chain vulnerabilities, exploring alternative sourcing options, and renegotiating contracts with suppliers can help mitigate the impact of rising costs. Simultaneously, businesses should develop a clear understanding of customer preferences, value propositions, and the competitive landscape to determine appropriate pricing strategies that strike a balance between profitability and market demand.

Specifically, a fit-for-purpose pricing operation includes:

• A deep understanding of costs: Businesses can delve into the underlying costs of their operations and gain insight into potential future cost paths. For many, this will include understanding and modelling the supply, demand, and regulatory dynamics of raw materials, services bought, and wages and salaries. Given volatility and uncertainty, it will also involve the creation and application of thoughtful scenarios against which to test alternative pricing approaches.
• A comprehensive understanding of customer and competitor behavior: Making pricing decisions—especially when cost pressures demand that those prices increase by a large percentage—is all about timing and magnitude. No business has a crystal ball to perfect these moves, but every company can analyze historical events, estimate reaction functions, test the waters with customers, and game alternative competitive scenarios. Given the sensitivity of bottom-line results to revenue fluctuations, such insights need to become a cornerstone of pricing decisions.
• A more frequent cadence of margin and price reviews: An inflationary environment necessitates a more agile approach to pricing. Annual reviews and changes to list prices are unlikely to allow the optimization of margins and market share. Indeed, while not appropriate for all sectors, it is useful to be reminded that many digital and online players make pricing decisions on a minute-by-minute basis. Whatever a business’s starting point, building the organizational muscle—and customer expectations—to be able to move quickly is likely to be a source of competitive advantage.
• Improved pricing discipline: Even when a company has a sound pricing strategy, its intentions can be undermined by lack of discipline in execution. McKinsey’s analysis shows that two-thirds of price improvements tend to leak out: for every £1 of price improvement, only 33p is in fact realized (See Exhibit 3). For example, the sales team may not have sufficient support for renegotiating with customers, or the company’s IT systems may require manual adjustments to reflect new prices. An across-the-board review of these practices, and an improvement in both processes and culture, may be required.
• Integration with other functions: It goes without saying that pricing needs to be fully informed by, and iterated, with a company’s procurement, property, HR, and marketing strategies. However, when customers’ wallets are getting squeezed by general inflation, it is also important to review, and redesign, products and services to be truly focused on solving customers’ pain points. Companies using design-to-value approaches have been well placed to offer better value to customers in an environment of rising prices.

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While there are promising signs that the current wave of inflation could have peaked in the UK, businesses need to remain vigilant. The abating inflation rate does not signify an end to price increases but rather a slowdown in their pace. Moreover, businesses need to recognize that inflation might stay higher for longer. In this environment, active and agile pricing strategies will remain core to maintaining competitiveness.

_{1. CPI annual rate: all items, Office for National Statistics, May 2023.}

_{2. Forecasts for the UK economy: a comparison of independent forecasts, HM Treasury, May 2023.}

_{3. The energy intensity of the Consumer Prices Index: 2022, Office for National Statistics, April 2023.}

_{4. UK NBP Natural Gas Futures, ICE, May 2023. Average of Winter 2023 and Summer 2024 contracts on 26 May 2023 vs. 29 August 2022. Full-year forward prices considered a better benchmark for underlying costs than daily spot prices.}

_{5. Customers to pay less for energy bills from summer, Ofgem, May 2023.}

_{6. Monetary Policy Report - May 2023, Bank of England, May 2023. Average over four quarters.}

_{7. Monetary Policy Report - May 2023, Bank of England, May 2023.}

_{8. Contributions to the 12-month rate of CPI(H) by import intensity, Office for National Statistics, May 2023.}

_{9. Wave 76 of Business insights and impact on the UK economy, Office for National Statistics, February 2023.}

_{10. Producer price inflation, UK: April 2023, Office for National Statistics, May 2023.}

_{11.Growth rates of output and input producer price inflation (PPI), Office for National Statistics, May 2023.}

_{12. EARN01: Average weekly earnings, Office for National Statistics, May 2023.}

_{13. Monetary Policy Report - May 2023, Bank of England, May 2023.}