19 July 2023
The Monetary Policy Committee (MPC) finally has something to smile about. The sharp fall in inflation in June will ease the pressure on the Committee to go for another bumper 50 basis points (bps) rate hike. Encouragingly, core inflation (which excludes volatile energy and food prices), and services inflation, which have both been worryingly sticky, fell to 6.9% and 7.2% respectively.
Today’s inflation numbers, combined with the first signs that the labour market is easing, mean the MPC can go with a 25 bps hike at its next meeting on August 3. That will bring a small but real relief to mortgage holders and business owners alike.
Drop in inflation driven by fuel but positive signs across the economy
The fall in headline CPI inflation from 8.7% in May to 7.9% in June brings inflation back into line with the MPC’s May forecast after overshooting it by 0.4 percentage points (ppts) in May. The biggest driver of the drop in inflation was fuel price inflation, which dropped to -22.7% from -13.1%. Food price inflation also fell from 18.3% to 17.3%. But it wasn’t just lower goods prices dragging inflation down. Restaurants and hotels inflation dropped from 10.3% to 9.5%, which helped to drag services inflation down to 7.2% from 7.4%.
What’s more, factory input prices fell by 2.7% year-on-year (y/y) in June, their largest fall since early 2016, excluding the pandemic. Output prices fell by 3.7% y/y, the largest fall since financial crisis. What’s more, food price inflation, which has been stubbornly high, has clearly peaked and based on commodity prices should fall sharply over the rest of this year. That suggests that inflation pressures further down the pipeline are easing, which should eventually translate into lower inflation.
The headline rate of CPI inflation still looks set to fall sharply over the remainder of this year. It probably will average about 7% in Q3 and 4.5-to-5.0% in Q4. The direct contribution of electricity and natural gas prices to the headline rate of CPI inflation will decline by 0.8 pp in July, when the price cap will be reduced by 17%, and then by a further 1.5 pp or so in October, when prices will edge down and the anniversary of a jump in prices will be reached.
We still expect inflation to drop to around 2.0% in the second half of 2024. Wholesale prices suggest that energy’s contribution to the headline rate will decline to about -1.4 percentage points by the end of this year, from +0.8pp in May. Additionally, energy bills will fall for most businesses when their current fixed-term contract expires. Meanwhile, the falls in input prices and food prices mean there is considerable scope for core inflation to drop back sharply over the rest of this year.
Admittedly, services and core inflation will likely take longer to fall back, but the latest surveys remain consistent with negligible growth in employment this year, which should result in an increase in labour market slack and a slowing in wage growth.
The policy takeaway
But, inflation is proving stickier in the UK than elsewhere. Bigger labour market shortages than in the EU and the US combined with more slowly falling energy costs mean the Bank of England still has plenty of work to do before it can relax. That suggests a 25 bps hike in August and another one in September. There may then be one last hike in November, but that will depend on the data between now and then.
In any case, with signs of an easing labour market and proof that inflation won’t defy gravity forever, the chances of interest rates having to go above 6% has significantly diminished over the last week.