Mixed inflation data confuses outlook for UK interest rates

With the headline figure falling and core inflation refusing to budge, what next for Britain's embattled households?

Shopping at an Asda supermarket, in Aylesbury, Buckinghamshire. Britain's annual inflation rate dropped sharply in July to below seven per cent, off the back of lower energy prices and in line with ecShow more

It is a confusing time for British households.

Wednesday's inflation figures from the Office for National Statistics showed the Consumer Price Index (CPI) stood at 6.8 per cent for the 12 months to July, down from 7.9 per cent the month before.

But core CPI, which excludes energy costs and food, remained at 6.9 per cent, unchanged from the June reading.

With core inflation remaining “sticky” and fears of its further entrenchment coupled with rising average pay, the Bank of England will not be lowering interest rates soon. Indeed, not many economists believe the Bank of England is close to pausing its tightening monetary policy cycle.

“One thing is absolutely certain,” said Russ Mould, investment director at AJ Bell, “the battle against inflation is far from over.”

Gas and electricity prices fell in July, providing much of the downwards pressure on inflation.

But while food prices remain high, food price inflation eased for items such as milk, bread and cereals.

The CPI all goods index rose by 6.1 per cent in the year to July, down from 8.5 per cent in June.

But the picture in services was gloomier – the CPI all services index rose by 7.4 per cent in the year to July, up from 7.2 per cent, according to the ONS.

So, while UK households took relief from falling energy prices and some relief from slowing food price rises, they were paying more for hotel rooms and eating in restaurants, where annual inflation stood at 9.6 per cent, compared with 9.5 per cent in June.

It cost less to fill up the car with petrol to drive on a staycation in July this year, compared to last year, as motor fuel prices fell by 24.9 per cent in the year to July.

But the price of hotel rooms and such like (which the ONS refers to as accommodation services), rose 12.2 per cent in the year to July, up from 11.3 per cent in June.

“Utility bills are the biggest driver of slower headline inflation, and food prices inflation continued to slow, which is good news for many households, said Janet Mui, head of market analysis at RBC Brewin Dolphin.

“That said, for domestically-generated services, inflation has strengthened due to a resilient labour market. Hotel inflation was a key driver, so for those looking at staycation it is getting costlier.”

That said, many observers felt that, overall, Wednesday's inflation numbers were a sign that things, if ever-so-slightly, were getting better.

“Headline inflation fell again, driven by falling household bills and clothing prices,” said Helen Dickinson, chief executive of the British Retail Consortium.

“Food inflation eased to its lowest level in almost a year. Many households will find their morning meals getting cheaper, with price drops in tea, coffee, milk, breakfast cereals and fruit.

“Meanwhile, clothing retailers mitigated the wet weather with larger discounts across their ranges.

“There remains potential stumbling blocks ahead. Russia’s withdrawal from the Black Sea Grain Initiative and subsequent targeting of Ukrainian grain facilities, as well as rice export restrictions could put pressure on some global commodity prices, slowing the fall in food prices,” she said.

Nonetheless, for many economists, the tightness in the labour market is feeding demand and keeping core CPI so “sticky”.

On Tuesday, the ONS revealed that the growth of average wages, excluding bonuses, reached a record 7.8 per cent in the second quarter of 2023, compared with a year earlier.

“Inflation will continue to fall through the remainder of this year, said Alpesh Paleja, the lead economist at the Confederation of British Industry (CBI).

“While this is welcome news for households, the Bank has been clear that they’re willing to keep interest rates higher for longer if needed, to rein in price pressures.

“So, at least for the time being, tighter financial conditions for households and businesses look like they’re here to stay.”

'Spooked mortgage markets'

One aspect of those tighter financial conditions may become apparent in the mortgage market.

Following a larger-than-expected fall in the June inflation numbers, many lenders have spent the past month trimming the rates on their mortgage offerings.

Lenders look to the swap market as an indicator of future moves by the Bank of England on interest rates and set their mortgage products accordingly.

Craig Fish, founder of Lodestone Mortgages, believes many lenders will now tread water given that the next set of UK inflation numbers are scheduled before the Bank of England's next rate-setting meeting in September.

“I think the mixed messages we are seeing today are likely to spook markets, potentially seeing swaps at least hold steady if not increase slightly,” he told The National.

One of the big unknowns at the moment is the relationship between the growth in pay, demand in economy and what happens when many mortgage-holders come to the end of their fixed rate mortgage – the so-called mortgage shock.

New research from Dashly, which monitors the UK mortgage market, shows that people renewing their mortgage over the next 12 months will be, on average, £3,456 worse off each year.

The study used a sample of 75,000 owner-occupier and buy-to-let mortgages and assumed that the borrowers would switch to the cheapest available product.

The conclusion was that the average monthly mortgage payment would rise from £747 to £1035, an increase of £288.

“This data reinforces what we are already seeing on the front line,” said Elliott Culley, director at Switch Mortgage Finance.

“It's a tough market right now and tough decisions are being made as people change their short-term plans to stay on top of rising mortgage costs.”

With the Bank of England now predicted to set base rates at 6 per cent by February next year, Mr Fish said that those in a position to remortgage should consider dong it sooner, rather than later.

“I suspect we will see base rates hit 6 per cent, if not a little higher to be fair, and while this doesn’t directly impact mortgage rates, the sooner clients take up an option the better is always the case. If things improve, it’s easy to switch,” he said.

Keeping a promise

In January, Prime Minister Rishi Sunak promised to halve inflation by the end of the year.

At the time, inflation stood at 10.7 per cent, and Mr Sunak pledged to bring it to 5.3 per cent by December.

It is a promise that British households will be keen to hold the Prime Minister to, and the Bank of England's forecasts say it is on target for now.

But some commentators are now saying that the stubbornness of core inflation in the face of 14 increases in interest rates, coupled with strong wage growth within a tight labour market, brings Mr Sunak's ability to keep his pledge into question.

“The Prime Minister's target to halve the rate of inflation by the end of the year was always a little odd as there is only so much the Treasury can do to influence the pace of price increases,” said Heidi Karjalainen, research economist at the Institute for Fiscal Studies (IFS).

“When the target was set, the Prime Minister may have hoped he could rely on falling in energy prices to do most of the work to hit it.

“However, the stubbornly high rate of price inflation for goods and services other than food and energy has put the target in jeopardy.

“With only four months to go, it no longer seems at all clear that inflation at the end of the year will have fallen by enough to achieve it.”

Halving inflation was Mr Sunak's “No 1 priority” and claimed the 6.8 per cent figure for July shows that “the plan is working”.

Nonetheless, the Resolution Foundation's research director James Smith believes despite the rapid fall in inflation so far this year, the Bank of England still “faces a daunting task in further taming price pressures”.

“Accelerating pay growth will make even the Prime Minister's promise to halve inflation hard to meet, let alone the Bank's mandate of reducing it to 2 per cent target,” Mr Smith said.

What happens next?

Further increases to interest rates have been priced into by the financial markets and it is predicted that the Bank of England's current cycle of monetary tightening will peak early in February next year when base rates are expected to be around 6 per cent.

Core inflation remains sticky, but there were a couple of technical reasons influencing this in the July figures. Firstly, the month witnessed a large increase in rents as many social housing tenants’ annual contracts rolled over and incurred a 7 per cent price increase. Also, some of the pricing pressures that might have normally appeared in August's figures made it into the July reading simply of timing issues in the month.

Nonetheless, Stuart Cole, chief macro economist at Equiti Capital, told The National, the unflinching level of core inflation is concerning.

“It is hard to escape the conclusion that once you strip out volatile food and energy prices then inflationary pressures appear to be quite firmly embedded, and particularly in the key services sector, an area where we have been seeing high wages growth as the hospitality and leisure industries struggle to attract staff.

“So I think the Bank of England will see the core rate as worrying and a sign that the upwards pressure we are seeing on wages growth is some way off from easing.”

Households are unlikely to see much in the way of relief for some time. For the Bank of England, there simply remains too much demand left in the economy, despite 14 rises in interest rates.

But raise them too much and the UK economy could be tipped into recession, which brings another set of problems. The big question for households is whether keeping Mr Sunak's inflation promises could ultimately risk those problems down the line.