UK inflation data released this morning revealed a big upside miss across all CPI measures, prompting a spike in the pound as traders upgraded their calls for the upcoming Bank of England monetary policy decision.
Headline CPI printed at 8.7% YoY, which whilst down from last months 10.1% significantly overshot pre-release expectations of 8.2%. More worryingly for the Bank of England, core inflation climbed by 0.6pp to a new high of 6.8% YoY, well above expectations and the BoEs own forecasts. This trend was reflected in a rise in services inflation as well, which has been highlighted by the BoE as a key indicator for underlying inflationary pressures, showing a rise of 6.9%. The market reaction to this stronger-than-expected set of numbers was swift, with OIS implied expectations now pricing more than one full hike at the June monetary policy meeting, and close to three more additional hikes now expected later this year. Whilst we continue to be more dovish than the broader market on the BoE’s expected terminal level, we appreciate that today’s release likely tips the BoE’s hand into hiking in June despite positive developments within the labour market.
Coming into today’s release, headline inflation had been expected to fall from the previous level of 10.1% YoY to just 8.2%.
This move was expected largely as a result of a spike in energy prices that occurred 12-months ago falling out of the consumption basket, and would have placed headline inflation below the BoE’s May forecast of 8.4% and significantly undershot February’s forecast of 8.7%. In fact, whilst electricity, gas and other fuel prices did contribute around 1.7% of the fall in the headline measure of inflation, this was offset by rises elsewhere, in particular upwards contributions from recreation and culture, transport, and communications. Accordingly, goods inflation fell sharply, growing by 10% in April compared with 12.8% in March, helped in large part by the decline in energy price growth. But with some forecasters having expected a modestly larger impact from the fall in energy prices, and anticipated a greater downward contribution from food inflation, which remained elevated at 19.0% YoY vs 19.1% in April, it does suggest that some of the projected fall in headline inflation has simply been postponed.
Services inflation beats BoE forecasts and is likely to set alarm bells ringing amongst policy makers on fears of sticky inflation
Stripping out the volatile components of energy and food, core CPI in contrast was expected to print flat at 6.2% YoY.
Instead, the robust growth seen today of 6.8% was well above pre-release expectations. This rise appears to have been fuelled by stronger-than-expected price growth in parts of the services sector, notably, recreation and culture, which grew at 6.3% YoY in April, but also communication and transport, which together provided a roughly 0.4pp uplift to headline CPI. The Bank of England has specifically highlighted services inflation in their communications as indicative of more sustained inflationary pressures. This was anticipated to rise modestly, printing at 6.7% in April before peaking at 6.8% in May and declining slowly over the coming months. However, printing at 6.9%, 0.2pp above the BoE projection for this release, services inflation beat all expectations. This does however correlate with some of the strong indications seen in recent months for wage growth, which despite signs of a cooling labour market, has remained robust, with average weekly pay excluding bonus increasing by 6.7% on a 3m/YoY basis in March.
The uptick in services inflation suggests that at least some firms in the sector are passing on these increased wage costs, which will set alarm bells ringing amongst policymakers concerned with embedded inflationary pressure and the potential for a wage price spiral.
In our view, whilst this latest release will clearly be troubling for the Bank of England, there remains a significant chance that the upside beat seen today represents falls in inflation that have been postponed rather than absent entirely. Energy and food prices should continue to fall mechanically over coming months, as the decline in commodities prices continue to filter through to consumer inflation. In addition, signs from the labour market are increasingly indicating slowing labour demand, with latest PMI releases for May suggesting that job creation, despite remaining positive, is beginning to slow markedly. In addition, the same report also highlighted improved candidate availability, which should mean further employment growth is less inflationary. Moreover, the ONS’ Business Insights and Conditions Survey indicated that just 30% of businesses in the accommodation and food services sector have plans to increase prices in June which is well below the 42% average seen in the past year. These dynamics should ultimately weigh on core inflationary pressures, bringing down CPI as expected.
As noted by Governor Bailey in evidence given to Parliament yesterday, a significant amount of monetary tightening is still to flow through to the real economy.
However, with the BoE retaining a bias towards further tightening and noting that risks to inflation forecasts are skewed to the upside, we think that today’s release tips the balance of risks towards a hike in June. In our view though, the market reaction to this latest release is overblown, with implied expectations currently predicting close to a further 100bp of rate hikes for the Bank of England. This is excessive given that underlying dynamics continue to point to slowing inflation across both headline and core measures in coming months, and given the Bank of England’s reluctance to take rates considerably higher as evidenced by the removal of explicit forward guidance. For these expectations to be vindicated, we would need to see significantly more evidence of embedded inflationary pressures to believe this magnitude of further tightening is necessary. The reaction of the pound to the rise in rate expectations has been mixed, spiking initially on the release, the move higher retraced almost entirely. This suggests that for FX markets, 100bp of hiking puts recession prospects and financial stability in the crosshairs once again, offsetting the positive benefits from additional carry.
Nick Rees, FX Market Analyst