Falling services inflation points to more rate cuts, despite rising headline

The July inflation data will make for happy reading at the Bank of England (BoE) this morning, despite the rebound in headline inflation to 2.2%. The big drop in services inflation to 5.2% in July, on the back of a significant slowdown in wage growth in June, suggests that underlying price pressures in the economy are easing quickly. While this probably isn’t a big enough drop to prompt another rate cut in September, it does indicate that the Monetary Policy Committee (MPC) was right to cut rates in August and that one, but possibly two more, rate cuts will happen later this year. 

Key drivers 

We knew that the big falls in energy prices in June last year dropping out of the annual comparison would push goods inflation up. Energy price inflation rose from -27.2% to 20.1%, which alone added almost 0.3 percentage points to the headline rate.

The big surprise was the sharp drop in services inflation to 5.2%, well below the 5.5% expected by the market. This was driven by a big drop in accommodation inflation from 9.8% to 3.9% - high prices by hotels is one reason why services inflation has been so sticky recently, but it is also volatile depending on what day the ONS collects prices. There was also a very sharp drop in airfare inflation from -0.9% to -10.4%.

Excluding airfares, package holidays and education — a measure the BoE has in the past called ‘core’ services inflation — shows annual services inflation fell to 5.4% from 5.8% based on our estimates.

Elsewhere, food price inflation edged up marginally to 1.4% from 1.3%. We think the disinflationary impulse from the category has all but run its course. 

What next? 

We expect inflation to rise to 2.4% in August due to further base effect, while airfares surge to reflect school holiday prices and hotel prices likely rebound a little. Looking further ahead, food and non-energy goods inflation have no further to fall now they have converged to producer output price inflation while Ofgem will likely hike the utility price cap by around 10% in October after wholesale energy costs have risen. Those components have accounted for almost all of the fall in inflation since October 2022. Getting inflation sustainably back to the 2% target will require services inflation to drop closer to 3.5%, but that will take time because wage growth remains strong. We look for CPI services inflation to fall around 5% by the end of 2024.

The policy takeaway 

Overall, today’s data combined with the pay growth data from yesterday suggests that price pressures within the domestic economy are easing quickly and should help the MPC sleep a little better tonight. 

However, alongside the decision to cut rates this month, Governor Andrew Bailey delivered the message that the BoE shouldn’t ease ‘by too much or too quickly’. As a result, the latest two data points probably are not enough to tip the balance towards a rate cut in September, but it does open the door to two more cuts this year, rather than just the one.

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