Inflation rose to 3.8% in July, up from 3.6% in June, and bang in line with the Monetary Policy Committee’s (MPC) forecast. That, in theory at least, keeps another rate cut on the table. However, inflation will hit 4% in September, making it difficult to justify another interest rate cut in November. It now feels more likely that the next rate cut will be in December or February because the MPC will want to ensure that inflation has peaked. While we still expect interest rates to hit 3.5% next year, these inflation figures mean it might take longer than initially expected to get there.

Seasonal inflation spike - food costs still a concern

The main drivers of the rise in headline inflation were food (4.9% vs 4.5%) and fuel prices (-6.7% vs -9%), as well as erratic components like airfares (15.5% vs 0.5%) and accommodation services (0.7% vs -1.9%).

The MPC won’t worry too much about the strong rise in airfares and accommodation services, which helped to push services inflation to 5% from 4.7%, because this primarily reflects seasonal effects from the summer holidays, which will unwind once the school holidays are over.

Rising fuel prices won’t worry the MPC much either. Oil prices have already fallen 5% in August so far, which should offset part of the recent rise in pump prices on garage forecourts.

However, what will concern the MPC is rising food inflation, which increased to 4.9% from 4.5%. This rise largely reflects rising global agricultural prices. Yet, food prices have risen faster in the UK than elsewhere. We take that as some evidence that supermarkets are passing on higher employment costs.

Interestingly, food price inflation has consistently outpaced the MPC’s forecasts of late. This could suggest higher wholesale agricultural prices are feeding through to supermarkets quicker than usual. Or, it could reflect stronger than expected price pressure. We already anticipate food price inflation will reach 5.5% at the end of the year, but this could easily hit 6% as supermarkets continue to pass on rising wholesale and employment costs to consumers.

What are the chances UK inflation stays high after September?

Looking ahead, as these rising food and fuel prices continue to put upwards pressure on the measure, we expect inflation to reach 4% in September.

We also see three upside risks to our inflation forecasts.

First, big tax rises in the Chancellor’s next Autumn Budget may be contractionary when it comes to growth, but if Rachel Reeves chooses to hike duties in the near-term by more than we expect, then this could prevent inflation from falling below 3% next year.

Second, growth averaged 0.5% per quarter in the first half of the year. This is a little faster than our estimate of the UK’s potential growth rate of around 0.4% per quarter. If underlying growth continues to be stronger than the MPC’s pessimistic assumption of 0.1% in the first half of the year, then inflationary pressures could build, rather than wane.

Third, inflation expectations look increasingly concerning. Given that food inflation has a disproportionally large impact on households’ inflation expectations and is set to hit well over 5% in December, there is a genuine risk that the MPC’s progress on disinflation will be derailed if households try to protect their incomes against the rising cost of their weekly shop.

For now, we still expect inflation to reach 4% in September, but it wouldn’t take much to push inflation over that psychologically important threshold.

A question of timing: when will the next UK interest rate cut be?

Despite the 20bps rise, July’s inflation uptick was in line with the MPC’s forecast. This keeps another interest rate cut this year in play.

However, with inflation set to hit 4% in September and the risk of it heading higher, rising inflation expectations could keep wage growth elevated.

Given that the MPC flagged concerns that “the disinflationary process had slowed and the risk of inflation expectations feeding through to second-round effects had risen” at its last meeting, we think the chances of a November rate cut now look slim. On balance, the next rate cut is now more likely to be in December or February.

Admittedly, this latest rise in inflation was largely driven by erratic seasonal components, which will give the ultra-dovish members of the MPC enough reason to continue their calls for rate cuts. Nevertheless, persistent services inflation and rising food prices will probably convince the majority of the MPC to vote for a hold in November.

However, if new tax rises in the Autumn Budget look likely to dampen growth, and the Chancellor avoids pushing up inflation with bigger duty hikes than expected, then the MPC may have the cover it needs for a rate cut at the end of the year.

Ultimately, we still expect rates to settle at around 3.5% next year. It might just take a little longer to get there than we previously expected.

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