Inflation falls slightly to 3.4% as MPC considers next rate cut

Inflation dipped to 3.4% in May, thanks to the Office for National Statistics (ONS) correcting an error to Vehicle Excise Duty (VED) calculations in April. Inflation will stay around 3.5% for the rest of the year, which will keep the Monetary Policy Committee (MPC) on its “gradual and careful” rate cutting path. We still expect two rate cuts, coming in August and November. However, rising energy prices from the latest conflict in the Middle East could push inflation closer to 4%. That would risk employees bargaining for bigger pay rises and reverse the recent progress on wage disinflation. We think in this scenario the MPC would skip a rate cut.

UK inflation drops due to ONS error

May’s drop in inflation largely reflects the correction to VED after April’s data error, which knocked 10bps off the headline rate. Airfares also unwound – falling from 16.2% to -3.9% – after surging in April thanks to a late Easter. Both of those helped push services inflation down to 4.7%.

Combining those two factors with falling inflation in other modes of transport and cheaper fuel prices, transportation as a whole knocked 35bps off May’s headline rate.

However, strong goods inflation offset some of that drop, rising to 2% from 1.7%. Clothing and footwear jumped 0.8%m/m as Easter sales finished. A potential concern for the MPC was food and beverage inflation rising to 4.4% from 3.4%, which could reflect firms passing on higher employment costs. This added 11bps to the headline rate.

Beyond the rise in food prices, we still see limited evidence that firms are passing on the increase in employment costs through prices. Granted, restaurant and hotels inflation has averaged 0.8%m/m since February, but this figure is lower than it was over the same period last year.

Upside risks to already elevated inflation

Inflation will continue to average around 3.5% until the end of the year due to April’s regulated price increases and tax rises. In fact, we don’t see inflation dropping below 3% again until April 2026.

The big risk to inflation comes from rising energy prices. Oil prices have risen more than $10 per barrel (pb) over the last week, which will probably lead to a five pence increase in prices at the pump over the next couple of months. Natural gas prices are rising too, which will put further upward pressure on the measure. A rule of thumb is that a $10pb rise in oil will eventually add 0.2ppts to inflation as higher fuel prices make their way through the economy. If prices rise another $10pb, then we could see inflation reach over 4% later this year.

What’s more, consumers and businesses remain hyper aware of inflation, which has driven inflation expectations up. If inflation reaches 4%, then it could prompt employees to start bargaining for bigger pay rises and force firms to raise prices to protect their profit margins. If that materialises, then inflation could head even higher.

Can the MPC still cut interest rates twice more this year?

May’s inflation figures are in line with the Bank of England’s forecast and the drop in services inflation is clearly good news for the MPC. If it wasn’t already, we think that makes a hold at tomorrow’s meeting a certainty.

Despite some dovish data over the last couple of weeks as the economy contracted, strong pay growth weakened and inflation dropped, so we don’t think that will be enough to change the MPC’s path.

Instead, we think strong wage growth, rising oil prices and inflation expectations, which are closer to 4% than 2%, mean the risks are tilted in favour of fewer cuts than the two we currently expect this year.

Given the risks around energy prices, MPC member Catherine Mann had previously highlighted that “4% is an important threshold for attentiveness”. In other words, that’s the level households no longer ignore increasing prices and start to bargain for bigger pay rises. What’s more, inflation has averaged over 5% since 2021, meaning households and firms are already more sensitive to inflation than before Covid-19.

This could undo the progress the MPC had been making on wage disinflation over the start of the year. We think that could prompt the MPC to skip a rate cut as they once again have to weigh on inflation to try and dampen second-round effects from wage bargaining and price hikes.

Ultimately, the MPC continues to walk a fine line. Our base case remains for two more cuts this year, which would leave interest rates at 3.75%. However, we think the risks are tilted to just one more cut.

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