UK inflation numbers surprise on the topside

Disappointing CPI prints from the UK this morning, which have come in above consensus and suggest a hard battle ahead for the Bank of England (BoE) as it strives to squeeze remaining inflationary pressures out of the economy. Although the annual core rate remained unchanged at 5.1%, both the annual headline and services rates rose by 0.1%, to 4.0% and 6.4% respectively. On a monthly basis headline CPI rose by 0.4%, suggesting an unadjusterd annualised reading much closer to 5%. The figures will be disappointing for the BoE and will temper market expectations regarding how soon, and far, interest rates will be cut this year.

On a more positive note, inflation is running lower than where the BoE was expecting in its November forecasts, while the softer PPI figures also released today point to an easing in pipeline pricing pressures going forward. At the moment the underlying trend remains that inflationary pressures are easing: two of the main contributors to the stronger reading today – air fares and increases in tobacco duties – will not remain a source of upwards pressure going forward. And the BoE will take comfort from the fact that services CPI, despite rising by 0.1% to 6.4%, is losing upwards momentum considerably quicker than anticipated in November, when it forecast an expected end-year reading of 6.9%. Indeed, the BoE’s preferred measure of underlying services CPI inflation, which strips out accommodation prices, airfares and non-private rents, actually fell from 6.5% in November to 6.4% in December. Certainly today's numbers are not all bad news and looking forward, while headline CPI is expected to rise further in January on the back of one-off base effects, it is then generally expected to steadily decline over H1 as lower energy prices and the feed-through from lower producer prices exert downwards pressure.

However, when the CPI figures are viewed in line with yesterday’s wages growth numbers, which despite continuing to soften remain at levels that will be of concern to the BoE, the picture is not quite so rosy and it becomes harder to see anything that might persuade the BoE to move away from its “higher for longer” message. Indeed, the concern may be that the falls we have seen so far in CPI are more the result of declines in global prices and energy costs rather than any underlying reduction in domestic inflationary pressures, suggesting the toughest part of the battle in bringing CPI back to target is still to be fought.

Despite Governor Andrew Bailey frequently warning of these challenges, the market has generally been expressing a much more sanguine view. Two-year gilt yields had fallen from nearly 5% in October to settle around the 4.15% level ahead of today’s data, while a first rate cut was largely expected to come in May, and with a total of around 125bps of easing being seen delivered this year. Today’s numbers have seen two-year yields trade up to the 4.27% level, suggesting an element of caution now being seen in these forecasts. And while a first cut being delivered as soon as May cannot be ruled out entirely (we expect the first cut to come in H2), 125bps of easing does look too optimistic for this year, with a more likely outcome being 100bps.