UK interest rate expectations retreat following softer CPI numbers

In what will no doubt have been privately welcomed by the Bank of England (BoE), today’s UK inflation figures for June finally showed both headline and core CPI heading lower in what is being interpreted as a signal that the aggressive monetary tightening delivered by the BoE is finally starting to have an impact.

The headline rate fell to 7.9% from 8.7% in May, comfortably beating expectations of an 8.1% print, while, perhaps more crucially from the BoE’s perspective, the core rate also fell, to 6.9% from 7.1%, the first decline since January, and again beating expectations for an unchanged reading. The headline rate has now matched the Monetary Policy Committee’s (MPC) inflation forecast contained in the May Monetary Policy Report and was likely met with a huge sigh of relief inside Threadneedle Street. Encouragingly, the slowdown in the core rate is broad based, with core goods CPI falling from 6.8% to 6.4% and core services CPI falling from 7.4% to 7.2%. Indeed, it is only the short spell of unseasonably warm summer weather seen in early July which boosted demand for outdoor clothing that has prevented the goods reading from falling further. Food prices are also starting to bear down on the headline rate, annual price rises slowing from 18.3% to 17.4% and increasing by just 0.4% on the month, sharply lower than the 1.3% average monthly increase seen over the past six months.

Going forward, downwards pressure on headline CPI looks set to continue. The 17% reduction this month in the energy price cap will instantly knock 0.8% off July’s CPI reading, while in Q3 food inflation should also fall sharply as we pass the one-year anniversary of the jump in prices caused by Russia’s invasion of Ukraine. Core CPI is also likely to continue falling, as evidenced by today’s PPI figures. These showed monthly output prices falling by -0.3%, the third consecutive month of decline, while core output prices posted a -0.3% fall on a three-month-on-month basis, the first fall we have seen in this measure since Q3 2020. This will exert downwards pressure on core goods prices going forward. Finally, the appreciation seen in sterling since the start of the year will also have a disinflationary impact. The MPC’s rule of thumb is that a 5% appreciation in sterling reduces CPI by approximately 1.5% over the medium term, ie over a two-year horizon. However, if sustained, the benefits of this appreciation may start to be seen a little earlier than usual in this cycle. Companies have been forced to adjust prices more rapidly than usual during the current cost of living crisis and may continue with this faster pace of repricing as cost pressures ease, given that they are likely to still be facing weak consumer demand.

The key question the markets will now be addressing is what today’s numbers mean for interest rates. Prior to today's release, market expectations were fully pricing in a 25bps increase in August with a 69% chance of a 50bps rise being delivered. Expectations for a 50bps rise have now fallen to 44%, with 2-yr yields correspondingly falling by approximately 26bps. Sterling has also lost some of its recent momentum as expectations of the UK’s terminal rate have similarly been scaled back. Having been trading around the 1.3030 level, cable has retreated to the 1.2950 area as the market has brought the terminal rate in from around the 6.50% level seen following the release of this month’s employment figures to closer to 5.75%. However, with CPI still at such elevated levels, and taking into account the strong wages growth numbers seen last week, the BoE may still yet conclude that another 50bps is justified, if only as an insurance policy to ensure that CPI does not start creeping higher again, akin to what happened with the core reading this year. Certainly the UK still faces a further tightening in monetary policy; the question is how aggresive the BoE considers it still needs to be.