Inflation rose to 3.6% in June, up from May’s 3.4% reading. This was driven by higher fuel inflation, which added 5bps to the headline rate, while smaller broad-based gains elsewhere also helped to push up the measure. We think inflation will remain around 3.5% for the rest of the year. This will keep the Monetary Policy Committee (MPC) on their ‘gradual and careful’ path, with the next cut coming in August. However, the risk is that households respond to above target inflation by pushing for bigger pay rises, which would undo the MPC’s recent progress on wage disinflation. In that scenario, the MPC would probably only cut once more this year.

Strong fuel inflation drives rise, food prices a worry for MPC

June’s rise in inflation mainly represents a strong rise in transport inflation, which added 13bps to the headline rate. Within this, fuel prices were the main driver, rising to -9%y/y from -10.9%y/y as a big fall last year drops out of the annual comparison.

A particular area of concern for the MPC will be rising food and drink prices which nudged up to 4.5% from 4.4%. The MPC had pencilled in a reading of only 3.4%. What’s more, households are particularly sensitive to food inflation. This raises the risk that household’s bargain for bigger pay rises, which could push inflation up further. As a whole goods inflation jumped to 2.4% in June from 2% previously.

Turning to services, inflation remained unchanged at 4.7%. This was in part due to weaker restaurants and hotels inflation (2.6% from 2.8%) helping to offset gains elsewhere. Importantly, underlying services inflation, which strips out volatile and indexed components as well as rents and foreign holidays, rose to 4.2% from 4%. This will concern the MPC as services inflation is more reflective of domestically generated price pressures.

There continue to be limited signs that employers are passing on the rise in employment costs from the budget in a significant manner. This could be why food inflation has surged recently, but gains have been strong in the EU too. What’s more, hospitality inflation has broadly been flat since April.

Upside risks will force MPC to be cautious

Inflation will continue to average 3.5% until the end of the year due to April’s big increases in regulated prices and tax rises. We expect a peak of 3.7% in September and don’t see inflation dropping below 3% until April 2026. However, there are a few risks that could push inflation higher.

First, while oil prices have fallen back to below $70 per barrel from recent highs as conflict in the middle east settles, the risk is any signs of escalating tensions could lead to a surge in oil prices. A $10 rise in the price of oil tends to add around 0.2ppts to inflation as higher fuel prices make their way through the economy. Admittedly, this risk looks to have subsided for now.

Second, consumers remain hyper aware of inflation, after close to half a decade of above target inflation by the end of the year. The risk is that strong inflation increases the likelihood that households try to bargain for bigger pay rises to protect their real incomes. Survey measures already suggest that households’ inflation expectations are elevated.

What does this mean for the MPC?

June’s inflation figures overshot the Bank of England’s (BoE) forecast. Combined with rising food prices and sticky services inflation, the MPC will be forced to remain cautious and raises the risk of fewer cuts. However, it shouldn’t stop them from cutting interest rates in August, before a further cut in November.

The MPC will have to balance above target inflation and strong pay gains with weak growth and a weakening labour market. Despite the risks we think the path for interest rates remains downwards as rates remain in restrictive territory and the MPC sounds increasingly concerned over the labour market.

However, we do think today’s reading will dampen some of the desire on the MPC to accelerate the pace of easing and continue to think that the risks are tilted towards just one more cut.

Inflation will continue to hover around 3.5% for the rest of the year and peak closer to 4%. Policymakers have continuously emphasised that 4% is the level where households and firms become more attentive to inflation. This could prompt further price rises and more aggressive wage bargaining. In fact, food prices which are particularly salient for household inflation expectations and came in 1.1ppts above the BoE forecast in June. This could undo some of the progress the MPC had been making on wage disinflation recently, despite a weakening labour market.

Ultimately, the MPC will have to continue to walk a tightrope as they balance a weakening labour market with elevated inflation. Our base case remains for two more cuts this year, leaving interest rates at 3.75%.

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