21 June 2023
Yet another higher-than-expected inflation print will pile more pressure on the Bank of England (BoE) to hike interest rates again tomorrow. Even more concerning than the stability in headline inflation at 8.7%, was the rise in core inflation to 7.1% from 6.8% in April and the jump in services inflation, which is more related to the domestic economy, to 7.4%, from 6.9%. However, we doubt today’s upward surprise will be enough to tip the committee into returning to bumper rate hikes of 50 basis points (bps), although don’t be surprised if the minority of the committee vote for one. A 25 bps hike tomorrow followed by at least one more 25 bps hike in August remains the base case. But clearly the risk is that interest rates must go higher than the 5% we currently expect.
Broad based inflation, but more positive signs ahead
The increase in inflation in May was partly due to rises in airfares inflation, from 12.6% to 31.4% (much of this has to do with the timing of when prices are collected. Index Day—when the ONS collects nearly all of its data—was before Easter in 2022 but after it in 2023, which means prices will be substantially higher.) However, our core services measure, which strips out airfares, education and package holidays, also rose to 7.5% in May from 7.2% in April, which suggests price rises in the services sector remain broad based.
All this was offset by a further decline in fuel inflation, from -8.9% to -13.1%, and the second fall in food inflation in as many months, from 19.3% to 18.7%, which explained why overall CPI inflation didn’t rise.
More encouragingly, factory input prices fell by 1.5% month-on-month (m/m) in May, their largest fall since early 2015, excluding the pandemic. 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, probably to about 4.5% by December and 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 CPI 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
In our preview for tomorrow’s Monetary Policy Committee (MPC) decision we forecast a 25 bps rise in June followed by another 25 bps rise in August, which would take interest rates to 5%, where the MPC could pause.
We still expect a 25 bps rise tomorrow, although this may now be accompanied by some more hawkish messaging. Admittedly, today’s data clearly raises the risk that interest rates have to go higher than that. However, with over half the tightening to date still to hit the economy, the BoE will be cautious about sounding the alarm too loudly. Financial conditions have tightened substantially since the BoE’s May meeting, thanks to the large rise in interest rate expectations, which will do some of the MPCs work for it.
Overall, we still think a peak of 5% is more likely than one of 6%. But the 6% priced in by financial markets no longer looks like such a leap.