The latest UK headline inflation figure surprised on the downside, coming out at 2.0% in May. The reading was down from 2.3% in April and meant that headline inflation reached the Bank of England target level for the first time in three years. Non-energy industrial goods (particularly household goods, clothing and footwear, and vehicles), food, alcohol and tobacco were the categories that contributed the most to the slowdown, while transport (particularly motor fuels) was a positive contributor.
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Despite the lower figure, the gap between overall goods and services inflation has continued to increase, from 6.9 percentage points in April to 7.2 percentage points in May — the largest gap on record. This probably shows that the pandemic shock is still a significant driver of price dynamics, with second-round effects from the initial spike in goods prices (reflecting supply bottlenecks, and changes to utilities prices following Russia’s invasion of Ukraine) driving services inflation higher. Recent papers from Bernanke and Blanchard and from Giannone and Primiceri have documented how the post-pandemic normalisation of inflation has come about primarily due to the easing of supply concerns, especially in the form of lower energy prices. Going forward, Fathom forecasts suggest that CPI inflation may be at or close to a trough, and is set to drift higher through the remainder of this year.
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Changes in utilities prices subtracted roughly a percentage point from headline CPI inflation in May, but that contribution is likely to turn less negative in July, moving close to zero by the end of the year. Meanwhile, wage growth remains elevated in both private and public sectors, and forward-looking indicators such as Indeed’s measure of advertised pay rates suggest that this picture may continue in coming months. Survey data and measures such as the ratio of vacancies to unemployment suggest that the labour market remains tight by historical standards, and is unlikely to loosen dramatically from here. Against this backdrop, we expect services price inflation — a simple measure of domestically generated inflation — to remain high, trending down only gradually from here. We also expect the decline in goods prices to be close to an end, as the contribution from a broad set of commodity prices, key input components in the price of goods, turns positive.
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While Fathom forecasts for RPI inflation are close to market-implied measures for the remainder of the year, we continue to see significant upside risks to inflation as we enter 2025. With labour market statistics still robust, we remain watchful of the broad-based rebound in lending that appears to be underway. In housing, mortgage lending has finally risen after hovering around zero growth for a year, while corporate debt issuance has posted the highest monthly gain in value since the second quarter of 2020.
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Further upside risks to UK inflation could stem from uncertainties around the new government’s fiscal plans, that are likely to become clearer only in the autumn budget. Overall, the Bank of England’s rate-setting task remains challenging, as it balances the short-term good news around headline inflation with a growing list of medium-term risks. We would err on the side of caution and focus on the risks; but the Bank of England appears to be taking the opposite view, as it has taken comfort from hitting the inflation target and seems ready to deliver a rate cut as early as August. In our opinion, the odds of a policy error are creeping higher. While a cut in August seems to be a growing consensus, an extended pause after the August move would allow room for the BoE to maintain an overall restrictive bias in monetary policy while remaining vigilant, especially if the inflation risks we have discussed materialise.
The views expressed in this article are the views of the author, not necessarily those of LSEG.
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