Inflation in the UK rises less than expected, fuelling speculation about interest rate cuts

UK consumer price inflation rose for the first time this year in July, official figures showed this week. However, the increase was smaller than expected as services prices – which are closely monitored by the Bank of England – rose less quickly.

Annual consumer price inflation rose to 2.2 percent, the Office for National Statistics said, after meeting the Bank of England's 2 percent target for two months. This was slightly below the median forecast of 2.3 percent in a Reuters poll of economists.

Following the release of the data, the pound fell sharply against the US dollar and financial markets priced in a 44 percent probability that the BoE would cut interest rates by a quarter of a percentage point in September. Before the data was released, the probability was 36 percent.

When the BoE cut interest rates from a 16-year high of 5.25 percent earlier this month, it said inflation rates of two percent each in May and June probably marked a low point in inflation.

The central bank expected the consumer price index (CPI) to rise to 2.4 percent in July and reach around 2.75 percent by the end of the year as the impact of sharp declines in energy prices fades in 2023. The CPI will then fall back to 2 percent in the first half of 2026.

“Today's data will give the Bank's Monetary Policy Committee some confidence that domestic price pressures are less likely to threaten a sustained return to the 2 percent target,” said Martin Sartorius, chief economist at the Confederation of British Industry.

UK inflation hit a 41-year high of 11.1 percent in October 2022, driven by sharp rises in energy and food prices following Russia's large-scale invasion of Ukraine, as well as COVID-19-related labour shortages and supply chain disruptions.

Consumer price inflation is still lower than in the eurozone, where the European Central Bank cut interest rates in June, and in the United States, where the Federal Reserve is expected to begin cutting interest rates next month.

Nevertheless, many households are still feeling the sharp price increases of the past two years.

In his reaction to the data, Deputy Finance Minister Darren Jones stuck to the line of the newly elected Labour government: the figures showed that the government had inherited a difficult economic legacy and had to make tough decisions to improve the situation.

Hotel costs are falling

The BoE continues to focus relatively strongly on long-term inflationary pressures, including services prices and wages, as well as the general slack in the labour market.

The latest data also showed that annual services price inflation fell to 5.2 percent in July from 5.7 percent in June, below all forecasts in a Reuters poll and the lowest since June 2022. BoE staff had predicted a decline to 5.6 percent.

The decline in services price inflation was due to a reversal of the sharp rise in hotel prices in June, as well as downward pressure on airfares, breakdown services, package holidays and cultural services such as live music.

Many economists attributed some of the price increases in June to concert tours in the UK, including by US singer Taylor Swift, but the ONS said it was not possible to establish a clear link.

Official data on August 13 showed that annual wage growth excluding bonuses slowed to 5.4 percent, its lowest in almost two years. While this is in line with economists' forecasts, it is still almost double the rate the BoE considers consistent with a constant 2 percent consumer price index.

However, those figures also showed a surprise fall in unemployment – albeit based on a survey that is currently being revised – and economists said the BoE was likely to remain cautious about cutting interest rates even after today's inflation data.

“Unless there is a significant shock to growth, this cycle of cuts will likely be gradual and most likely quarterly. Investors betting on rate cuts soon will therefore be disappointed,” said Aaron Hussein, global market strategist at JP Morgan Asset Management.

Financial markets have priced in further interest rate cuts by the BoE of 0.49 percentage points for the rest of the year; before the data was released, it was only 0.46 percentage points.