CPI inflation: Unexpected fall in inflation calls further rate hikes into question

20 September 2023

The surprising drop in inflation from 6.8% in July to 6.7% in August, after the Monetary Policy Committee (MPC) had expected 7.1%, makes it more likely that they will opt to keep interest rates at 5.25% at its meeting tomorrow. However, with headline wage growth still running at 8.5%, a majority of the committee is likely to determine that it is just a little too early to press pause on its rate hiking cycle. But, today’s data does make it more likely that if interest rates rise tomorrow, it will mark the peak of this cycle. 

Drop in core and services inflation especially encouraging

The drop in inflation was driven by sharply lower energy price inflation (7.8% to 3.2%) but food price inflation also dropped (14.9% to 13.4%). Big drops in inflation in the recreation and culture (6.5% to 5.8%) and restaurants and hotels (9.6% to 8.3%) are especially encouraging as inflation has been sticky in these categories as consumers have focused spending on experiences. That was more than enough to offset the upward pressure from higher fuel prices, which rose by 3.8% in August. 

More importantly, for the MPC at least, than the headline rate, which is impacted by things it can't influence like international oil prices, is core and services inflation. Here there was even better news. Core inflation, which strips out volatile energy and food costs, fell from 6.9% to 6.2%. And services inflation, which the MPC pays close attention to because it is closely related to price pressures in the domestic economy, dropped from 7.4% to 6.8%.

Admittedly, part of this was due to a 2.1% month-on-month drop in airline fare prices, well below the 13.3% average increase in the 2010s. The drop in August is related to the timing of when prices were collected, around the summer holidays. However, the Bank of England’s (BoE) core services measure, which strips out airfares and package holidays, also eased, suggesting a more widespread cooling in price pressure. The measure dropped to 6.8% from 7.3%, based on our calculations. 

What’s more, factory input prices fell by 2.3% year-on-year (y/y) in August, and output prices fell by 3.4% y/y, a reliable guide that goods inflation will continue to fall. That suggests that inflation pressures further down the pipeline are easing, which should continue to translate into lower inflation. 

What next? 

Looking ahead, the headline rate of CPI inflation likely will edge up in September, but will then resume its decent in October and finish the year slightly below 5%.

The direct contribution of electricity and natural gas prices to the headline rate of CPI inflation will decline by a further 1.5 percentage points (pps) or so in October, when prices will edge down and the anniversary of a jump in prices will be reached, but this will be slightly offset by the recent increase in fuel prices. 

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 pps 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, eventually, a slowing in wage growth.

The policy takeaway 

The obvious question following the softer than expected August CPI report is whether it will change what the BoE does at its September meeting.

The scale of the surprise means we now think there is a material risk the central bank chooses to pause this month. Indeed, financial markets are now pricing a roughly 50% chance of no rate hikes tomorrow. But the strength of wage growth suggests to us that the MPC will opt for one more rate hike, taking interest rates to 5.5%. That will probably be the last one though. By the time we get to November, when the next MPC meeting is scheduled for, it should be clear that inflation and wage growth are falling.


Instead, the MPC might opt for a dovish raise. This would entail raising interest rates by 25 basis points but signalling that interest rates are now at their peak. 

Whatever happens tomorrow, don't expect cuts until late next year.