UK headline inflation falls for second month, helped by lower energy prices

What happened?

UK Consumer Price Index (CPI) year-on-year fell to 6.8% to end-July, slightly above expectations of 6.7% but in line with the Bank of England’s (BoE) forecast. It’s a marked improvement from the previous reading of 7.9%. However, core CPI — not including food and energy — was unchanged at 6.9%. The BoE also referred to a core services measure (excluding airfares, package holidays, and education) that increased year-on-year to 6.2% from 5.9%.

Falling energy prices were the significant reason behind the fall in headline CPI. These were rolled onto a lower energy price-cap level that saw the price of gas drop 25.2% month-on-month, as prices at petrol stations were 25.0% lower year-on-year.

Increases in food prices remain in double figures, although they are comfortably past their peak from the first quarter of 2023. The challenge for the BoE now, as illustrated by the chart above, is the upward pressure coming from domestic sources.

July’s inflation data follows yesterday’s labour market overview, which showed average regular weekly pay hit an all-time high of 7.8% for the three-month period from April to June 2023. This was the case despite unemployment unexpectedly climbing to 4.2% from 4.0% previously.

Of note was the impact of labour disputes — specifically the one-off payments made to public sector workers, which saw their pay (including a bonus) increase 16.2% year-on-year. As labour market data is a month behind inflation data, real wages remain negative as CPI was 7.9% for the 12-month period to end-June. Official figures use the CPIH[1] measure, which shows real wages growing at 0.5%.
 

How have markets reacted? 

On the labour market data, markets revised their expectations of the BoE adding 25 basis points (bps) to the base rate to a certainty, with an outside chance of the hike being 50bps. Inflation data being largely in line with expectations has not moved base rate expectations. The pound sterling was 0.5% higher on the labour market data before giving back most of those gains by the end of the day. Sterling is up again today; it rose 0.35% on the inflation data.

The base rate is still expected to peak in March 2024, but the expectation is now marginally higher at 5.9% from 5.8% (before the labour market and inflation data). This means the market is anticipating three further rate hikes for the UK, giving it the longest hiking cycle compared to the US and Eurozone. This expectation was reflected in the 10bps increase yesterday across the UK gilt curve, with the 2-year trading at 5.13% and the 10-year at 4.60%.

Rising inflation concerns on labour market data saw a sell-off in the FTSE 100, but the index was flat on the actual CPI data today. Insurers have done well, as this sector has sticky prices and has passed big price increases to its customers. Relatively high inflation has caused investors to act with caution toward UK equities, although there are more long-standing issues which have been challenging for UK equities.
 

What is our outlook on the situation?

Disinflation is an imperfect journey. Not every data point will perfectly support the disinflationary narrative. Services inflation has proven to be rather sticky for several developed economies — largely owing to unique post-pandemic consumption habits and labour market constraints.

But we believe that the disinflationary process is underway. Inflation overall is likely to fall quite sharply as we move into quarter four 2023 (near-term higher fuel and alcohol prices are expected). Month-on-month data showed July headline CPI falling 0.5%. We are rolling out of some sharp monthly increases experienced in half two 2022 (the monthly increase in October 2022 alone was 2.0% due to energy prices). As a consequence of lower headline CPI, wage growth and core inflation are likely to fall as many wage demands and service contracts reference the CPI rate.

The breakdown of CPI shows all categories — excluding energy — are expanding well above the BoE’s 2% target, and so the BoE is likely to increase rates at its September meeting. However, a subsequent sharp fall in inflation may result in fewer hikes than the market is currently expecting.

Imported inflation is falling, and this will improve further as the sterling is stronger relative to where it was 12 months ago. The markets have been reacting to backward-looking data, and perhaps more consideration needs to be given to the future impact of hikes (including those already executed). Although the UK economy has been more resilient than expected, it has struggled to keep pace with that of its G7 peers.
 

What are the risks to our view?

Domestically generated inflation continues to remain high, and the BoE could be forced to increase the base rate further. Unemployment has risen, but the labour market is still tight by historical standards. Progress in lowering the inactivity rate has been slow. As rates are likely to be higher for longer, this needs to be balanced, and could put the UK economy in greater jeopardy further down the line.

 With contributions from Kristina Hooper and Paul Jackson.