Softer UK inflation numbers still do not point to an early cut in interest rates

A set of inflation figures from the UK this morning that, on face value, appear to show the Bank of England’s (BoE) lengthy battle to return CPI back to target has been won. However, beneath the surface, the picture remains less rosy, with the implication that today’s figures do not mean an interest rate cut will necessarily be delivered soon.

Today's inflation report finally showed UK headline annual CPI falling back to its 2% target in May, the first time it has been there since July 2021. The move was widely expected by the market and as such came as no surprise. Non-energy industrial goods inflation was a key driver of this fall, showing an annual growth rate of -0.1% in the year to May compared to the 0.6% equivalent reading seen in April. A large fall in food inflation also contributed, falling to just 1.7% y/y compared to the 2.9% reading seen in April. Elsewhere, a 0.5% monthly fall in used car prices, plus weaker household and recreational goods price, also helped to move CPI lower.

However, it was not all good news, with the other measures of inflation looking less encouraging. On a monthly basis, headline CPI rose by 0.3%, which, despite printing 0.1% below consensus, will be disconcerting for the BoE given that this represents an annualised rate of inflation of some 3.6%. And the annual core rate of CPI printed at 3.5%, a level that appears too high to allow rates to be cut yet. But perhaps most worrying for the BoE will be the rate of growth of services inflation, which fell by only 0.2% to leave the annual rate growing by 5.7%. The 'stickiness' being seen in this key inflation metric has been referenced on a number of occasions by the Monetary Policy Committee (MPC) as a key concern, particularly so given the dominance of the services sector in the UK economy; it is hard to argue inflationary pressures are attenuating and on a sustainable path to grow by just 2% per year when services inflation is falling so slowly.

And going forward, the outlook is similarly not looking quite so rosy as today’s headline number suggests, with CPI widely forecast to begin rising again over the summer months to move back closer to the 3% level by year end. The downwards pressure that has been exerted on food and non-energy goods prices looks now to be largely exhausted, as the inflationary drivers of these items have now largely converged with producer output price inflation, while energy prices are expected to increase by around 12% this October when the UK energy regulator, Ofgem, raises the default energy tariff faced by most UK households in line with rising wholesale prices. Tellingly, these three components alone have accounted for almost all the fall in headline CPI seen since it peaked at 11.1% in October 2022.

On balance, therefore, the underlying inflation picture rules out an interest rate cut being delivered at tomorrow’s (20th June) MPC meeting – if not for political reasons as much as economic ones. With both core and services inflation still running significantly above target, and the outlook for CPI to increase going forward, the MPC will not want to take any chances in allowing the inflation genie to escape the bottle again given the hard work it has taken to get to this point. And of course, there is also the on-going problem of wages growth still being too strong and threatening to stoke inflationary pressures higher; the MPC will want to see progress being made in bringing wages growth down, as well as core and services CPI, before being comfortable cutting rates.

But of course, focusing too much on these risks to the inflation outlook overlooks the point that headline CPI has returned to target and, even under the most pessimistic scenario, is not expected to rise much higher than 3% going forward, less than half the rate it was when interest rates were increased to their current 5.25%. As such, we believe the room exists for rates to be cut this year and that an easing policy stance is the right response to the generally weaker inflationary environment now being seen. Accordingly, we still expect a first cut will be delivered in September – August looks too soon given the need for wages growth to slow and core/services CPI to soften further – but that further easing thereafter will be only gradual, with only one more cut expected after September before end-year.