CPI inflation: Inflation back at 2% but too little too late for MPC

Today’s news that inflation has fallen back to 2% for the first time in three years will bring a bit of cheer to Rishi Sunak, but it’s too little, too late for the Monetary Policy Committee (MPC) to cut interest rates tomorrow. What’s more, another miss on services inflation has reduced the chances of an August rate cut.

Key drivers 

The slowdown in headline inflation from 2.3% in April to 2% in May was driven by a fall in goods inflation to -1.3%. A big part of this was a further easing in food inflation from 2.9% in April to 1.7% in May, and with food producer price inflation at just 0.2% in May, food price inflation will probably soon fall to zero.

However, services inflation, which is a better measure of underlying price pressures in the economy than headline inflation, missed expectations again, only slowing to 5.7% versus expectations of 5.5%. Within the services bucket, airfare, accommodation and communications all registered higher-than-expected price increases. 

What next? 

Looking ahead, we expect inflation to remain around 2% in June and then gradually creep up over the rest of the year. Ofgem will likely hike the utility price cap by 12% in October after wholesale energy costs have risen and although food price inflation probably has a little further to fall, we’ve probably seen most of the big drops now. 

What’s more, the surprising strength in services inflation is probably at least partly due to firms passing on the massive increase in the National Minimum Wage in April - if that is the case then this may be more of a one off hit to prices than a change in the underlying inflation dynamic.

The policy takeaway 

The stickiness of services inflation will raise concerns on the MPC that underlying price pressures in the economy aren’t slowing as quickly as expected. This essentially rules out an interest rate cut tomorrow and makes an August interest rate cut less likely. 

However, we aren’t ruling out an August rate cut. The MPC has shown some tolerance for volatility in the data of late – in the run up to the May meeting, it was relaxed about the small upside surprises in services inflation. What’s more, it seems likely that services inflation in May was still being bolstered by the impact of the 9.7% rise in national minimum wage in April, which was a one-off, as inflation in the restaurant and hotels category only slowed by 0.2 percentage points. 

We expect inflation to fall below 2% in June, setting the stage for the MPC to cut interest rates in August. Inflation is likely to average a little above 2% for the rest of the year giving the Bank plenty of room to deliver rate cuts. But sticky services inflation will make the MPC more cautious about cutting interest rates. The first rate may not come until September now and we may only get two this year.

The election, and more importantly any fiscal event, will probably come too late to have much impact on the interest rate profile this year, but the outlook for 2025 partly depends on whether a new government is forced into raising more revenue in the next parliament, which could give the Bank more room to cut interest rates or whether it borrows more, which would argue for fewer rate cuts. Our base case is for interest rates to end next year at 3.5%.

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