Falling inflation masks domestic price pressure

UK CPI inflation slowed to 6.8% in July (from 7.9% in June), largely as a result of a downward adjustment in the Ofgem energy price cap. Therefore, the fall in the headline rate was widely anticipated. However, an unexpected acceleration in services inflation, accompanied by a pick-up in wage growth in June, firmly underscored the stickiness of domestic price pressures.

Continued strength in these measures will limit how far and how quickly the headline rate can fall. It will also likely concern the Bank of England, thus raising the likelihood of further rises in interest rates ahead. Although the Bank appears to be approaching the peak of its rate tightening cycle, the Monetary Policy Committee (MPC) has stated that interest rates will have to be “sufficiently restrictive for sufficiently long” to bring inflation back to target. Therefore, businesses can reasonably expect tighter financial conditions to prevail for the foreseeable future.

We do still expect that inflation will fall over the coming months, as base effects in food, fuel and energy unwind further and pipeline cost pressures continue to ease. Higher interest rates will also increasingly weigh on household spending, especially as some households face rising mortgages payments later this year. Even so, the cost pressures generated by a tight labour market will likely keep inflation well above the Bank of England’s 2% target for the rest of this year at least.