CPI inflation: Stickier inflation means cautious MPC, but June rate cut still in play

The drop in inflation to 3.2% in March, leaves it slightly higher than the 3.1% the MPC was expecting. But this doesn’t change our view that inflation will fall to 2% in April and spent most of the year below the target rate. Admittedly, it does make a June rate cut slightly less likely, but there will be plenty of data and events between now and then that have a far bigger impact than the March data. For now then, we are sticking with our view that the first rate cut will come in June and be followed by two more leaving interest rates at 4.5% by the end of the year.

The drop in inflation to 3.2% in March, leaves it slightly higher than the 3.1% the MPC was expecting. But this doesn’t change our view that inflation will fall to 2% in April and spent most of the year below the target rate. Admittedly, it does make a June rate cut slightly less likely, but there will be plenty of data and events between now and then that have a far bigger impact than the March data. For now then, we are sticking with our view that the first rate cut will come in June and be followed by two more leaving interest rates at 4.5% by the end of the year.

Key drivers

Inflation dropped from 3.4% to 3.2% in March compared to expectations of a fall to 3.1%. The good news was that both core inflation, which excludes volatile components like food and energy, fell to 4.2% and services inflation, which is closely related to price pressures in the domestic economy, dropped to 6.0%. What’s more, elsewhere, the disinflationary momentum in food prices continues, slowing from 5% from 4%. However, there was considerable strength in restaurants & hotels and recreation & culture inflation indicating that demand for these services remains strong.

What next?

Looking ahead, it remains likely that the headline rate of CPI inflation will continue to fall over the next few months. We expect it to be about 2.0% in April and then modestly undershoot the 2% target over the following six months. Ofgem will cut the energy price cap by 12% in April, food CPI inflation will continue converging to weaker producer output price inflation over the next six months as the anniversary of chunky price rises in early 2023 is reached.

The outlook for services CPI inflation remains less clear, given uncertainty about labour market tightness and the potential impact of April’s near -10% increase in the National Living Wage on overall labour costs. Nonetheless, services firms’ other costs are rising less quickly and energy bills will fall for most businesses when they renew their fixed-price deals with suppliers.

The policy takeaway

The obvious implication from the strong wage growth yesterday and stickier inflation today is that rate cuts will be delayed. Indeed, financial markets have pushed back the timing of the first rate cut from June to August this week.

However, we think this would be a mistake. In our view, the MPC would be fully justified in cutting in May and in cutting rates more aggressively than is currently priced into the market. With inflation likely to be below the 2% target for most of the next two years, rates are clearly well into restrictive territory and are holding back the economic recovery sorely needed by the UK. After being late to increase interest rates during the first part of the cycle by relying on backward looking labour market data the MPC risks being late to the party again.

While it’s true that annual headline pay growth in the private sector is 5.8%, this is primarily due to large increase in pay this time last year. Annualised pay growth over the last six months, which is a better measure of current pay pressure, is below 3%, consistent with the MPCs 2% inflation target. What’s more, there is now clear evidence that unemployment is rising. A looser labour market combined with lower inflation means that pay growth will slow sharply in the second half of this year, removing the risk of a wage-price spiral. By moving proactively to cut interest rates, the MPC could help to kick start the economic recovery without any real risk of higher inflation becoming entrenched.

That said, the MPC is clearly still nervous about the outlook for inflation. As a result, we expect it to use the May meeting to lay the ground for future rate cuts by significantly reducing its inflation forecast and changing its forward guidance. The first interest rate cut will probably then come in June. By then the MPC will have hard data confirming that inflation has fallen back to its 2% target and will have been able to see the impact of the near 10% increase in the national minimum wage in April.

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