Sharp fall in UK headline inflation; but the core rate remains a concern for the BoE

The rate of annual headline CPI for the UK fell sharply today, as expected, driven primarily by a sharp drop in the default energy price tariff that the majority of UK households pay. In addition, downwards pressure was also felt from falling motor fuel prices and slowing food price rises. In total, these pressures were enough to see the headline rate fall from 7.9% to 6.8%, printing slightly higher than the 6.7% rate expected. However, it was not all good news, as the key core rate remained unchanged at 6.9%, rather than falling to 6.8% as expected, and this will be concerning to the Bank of England (BoE) as it battles to return CPI back to target.

Given the BoE's focus on the core CPI rate, it is this number that plays the dominant role in determining monetary policy decisions and there are some valid reasons for explaining its lack of movement today. July saw a large increase in rents as many social housing tenants’ annual contracts were rolled over with a 7% price increase applied. And the relatively late timing of the Index Day this July – the latest since 2006 – may have seen this month’s reading capture some additional pricing pressures that would normally be seen in the August print. On the more positive side, producer price data is pointing to the possibility of easing pricing pressures going forward, with annual producer input prices recording a -3.3% fall while businesses in the services sector still reporting elevated concerns over high energy prices fell to just 9%, considerably lower than the average 19% figure seen last year, and suggesting that the pressure to raise prices this creates is similarly easing. And the appreciation seen in sterling since the start of this year will help to lower input costs.

But whatever the forward evolution of core CPI, today’s number will be an unwelcome development for the BoE, as it raises the concern once again that the impact of the monetary tightening delivered to date is failing to provide the drag on economic activity and spending that was expected. And read in conjunction with yesterday’s strong wages growth numbers, almost certainly leaves the BoE concluding that further interest rate rises are needed if CPI is to be returned to its 2% target.

Expectations of the UK terminal rate have already moved back to the 6% mark on the back of this week’s data, and given the lack of solid downwards momentum being seen in CPI currently, it may well prompt the BoE to consider delivering another 50bps hike at its September meeting in order to try and stamp its authority on pricing developments. Indeed, in light of the fact that the triumvirate of GDP, wages and CPI data are all continuing to show unexpected robustness, the arguments it would need for such another large hike are probably already in place.

Having seen its credibility suffer after getting the ‘transitory’ inflation argument so wrong, and from the somewhat clumsy policy signalling it has provided to the market over the past couple of years, the longer this apparently difficult battle to bring CPI back towards target takes, the more the BoE’s standing in the market will shrink, ultimately leaving it in the position of needing to tighten monetary policy more tightly than might otherwise have been the case. It may ultimately be this consideration that sees it pull the trigger on another big interest rate hike next month.