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The last inflation report before the Bank of England’s August 3rd meeting provided signs of relief for MPC members this morning as June’s data finally managed to undershoot market expectations after four successive upside surprises.
Printing at 7.9% YoY in June, headline inflation fell by 0.8 percentage points from May, considerably below consensus expectations of 8.2% but landing in line with the Bank’s spot estimate for inflation back in May’s Monetary Policy Report. However, owing to upside surprises earlier in the quarter, the pace of disinflation in June did little to bring the average rate of inflation down towards the Bank’s Q2 forecast of 8.2%, with the average rate currently sitting 0.2pp higher. This, alongside May’s wage data, underscores why the Bank of England accelerated the pace of its hiking cycle at the last meeting back in June. However, inflation conditions are starting to improve, highlighted by today’s inflation report and June’s labour market data, which showed labour demand cooling considerably.
As a result, markets are now beginning to price a 25bp hike by the Bank of England in August as their base case, with risks tilted considerably to the upside.
The repricing in markets this morning brings swap pricing closer towards our view that the BoE will hike twice more by 25bps to a terminal level of 5.5%, with the implied terminal rate now back below 6% for the first time since the June 21st meeting at 5.8%. The dovish repricing of Bank Rate expectations is currently weighing on sterling, with the pound down 0.6% against the dollar, reversing much of last week’s rally following the softer US inflation release.
Pricing of a 50bp hike at the August meeting dips below 50% following today’s negative surprise in headline inflation
Favourable base effects drove the bulk of the disinflation in the headline measure, supplying a 0.8 percentage point drag that was only partially offset by a 0.1% MoM increase last month.
On a component level, disinflation in transport (-0.42pp) provided the biggest downwards contribution, followed by food and non-alcoholic beverages (-0.11pp), restaurants and hotels (-0.07pp) and household goods (-0.07pp). Interestingly, the only positive contribution to the year-on-year measure came from clothing and footwear and communication, both of which added a statistically insignificant 0.01pp. Despite providing a drag on the headline measure from May, food and non-alcoholic beverages (+1.97pp) and housing and household services (+1.75pp) continue to be the largest contributors to inflation as a whole.
Due to base effects, the monthly pace of price growth is a better barometer of current inflation dynamics, and here the picture remains positive albeit somewhat more mixed than the year-on-year statistics.
The pace of inflation cooled considerably from 0.8% in May to 0.1% MoM in June, driven largely by transport prices falling outright by 0.7% MoM and the pace of food inflation falling by two thirds to 0.4%. As such, goods inflation fell by 0.2% on the month. However, the same story wasn’t shown in services inflation, which continued to print at an uncomfortable pace of 0.5% MoM, down just 0.2pp from May. This was largely due to still strong price growth in communication (+0.8%) and restaurant and hotels (+0.5%). Ultimately, the still strong level of monthly services price growth led to the year-on-year rate of services inflation to print at 7.2%, considerably above the Bank of England’s projection of 6.7% YoY. Should the BoE wish to insure against upside inflation risks with another 50bp hike in August, this will undoubtedly be one of the measures used to relay such a decision.
Headline inflation falls back in line with the BoE’s forecasts, but only due to considerably larger goods disinflation
Having been forced into reaccelerating policy tightening at the June MPC meeting in a move that screamed panic, seemingly in response to a hot CPI print that dropped just one day, today’s inflation undershoot will come as welcome relief for the BoE.
But in many senses this just exchanges one policy headache for another as the BoE will now need to weigh up the green shoots within the latest inflation and labour market reports against the fact that inflation has proven considerably more resilient than they had expected year-to-date. Not only that, but the key services metric remains well above Bank staff projections and the pace of wage growth remains elevated. So whilst this morning’s inflation release appears to tip the balance of risks to a 25bp hike in light of preliminary signs of disinflation, this is far from a done deal in our view. If the Bank does want to ease the rate of hiking, Governor Bailey will have some explaining to do.
In particular, he will need to communicate why they are now less concerned than they were in June, especially as fears of a feedback dynamic between wages and prices that forced last month’s jumbo rate hike in the first place haven’t visibly dissipated.
And it is certainly worth noting that the BoE has been burnt by preliminary signs of disinflation earlier this year, something that policymakers will be wary of repeating. Despite this, we think a weakening labour market and today’s soft data should be just about enough for BoE policymakers to slow the pace of tightening, especially given that inflation will continue falling rapidly over coming months due to base effects, cooling goods inflation, and less pressure from energy markets. Therefore, we maintain our base case for a 25bp hike from the BoE next month, but risks to this remain skewed to the upside and a larger 50bp hike. For FX markets, this should keep sterling fairly well contained below recent highs barring any significant sell-off in the broad dollar.
Authors:
Simon Harvey, Head of FX Analysis
Nick Rees, FX Market Analyst