As We Expected, UK Core Inflation Steady, Fade the Hawkish Reaction

Summary

• As we had expected, July UK headline and core inflation beat expectations, driven by rises in rent prices.
• The BoE should not take this hawkishly. It is roughly in line with their estimates, and they are focused on the details.
• Services inflation, while higher than the BoE’s estimate, continues to add to our conclusion that wages are not the main driver of cost pressures, and that the BoE will not need to hike to where the market is pricing.
• They will get another labour market and inflation outturn before their decision in September.

Market Implications

• Yesterday’s labour market release had a hawkish headline, but more dovish detail. We noted then that there should be better value fading hawkishness after the July inflation release.
• This has now come to pass, the outturn adds to our conviction to fade hawkish pricing for the BoE, especially vs the Fed and ECB.

Rent Drives Core and Headline Beat

UK headline YoY inflation dropped 0.9ppt to 6.8% YoY on the back of (widely telegraphed) household energy price moves, this was a stronger print than consensus had forecast (+6.7% YoY). As we had warned, the strength came from the core reading (+6.9% YoY, cons: +6.8%), and within this (as we had expected) from the rental space, which sees strong quarterly revisions. In this regard we are not surprised by the outturn, nor do we take it to be hawkish for several reasons:

1. Monthly headline inflation is approximately in line with the BoE’s MPR projection.
2. Monthly core inflation is approximately in line with the BoE’s MPR projection.
3. Rental inflation reflects the pass through of monetary policy – not demand or cost pressures. It is an increased pressure on the economically weakest households (renters).
4. The BoE warned it would track the details not the aggregates most closely – if this is the case there is no reason for them to see it as hawkish.

On this basis, as we advised after yesterday’s labour market print, there is now good value in fading BoE hawkishness.

Durables Goods See Less Discounting than Usual

Delving into the sectors, several things stand out beyond the strong decline in housing inflation (on the back of the energy price cap change):

1. Discounting remains weak in durables: clothing inflation continues to overshoot, with the discounting seen in July significantly less than typical. Furniture, too, saw less discounting, as in April.
2. Communications saw strong deflation in the month – when typically it is roughly flat in July.
3. Food inflation is looking relatively benign, even if it is a little above typical.
4. Accommodation inflation ticked higher.

Services Inflation Rises on Rent and Transport

Services YoY inflation ticked up again to +7.4% YoY (from +7.2% prior), this remains significantly above the BoE’s monthly projection (Chart 4). The measure saw most support from rental inflation, followed by transport services (air and road in particular), and transport maintenance/repair (Chart 5).

Of these, as we have described in great detail in the past, rental inflation is driven by the UK’s buy-to-let market reacting to higher interest costs (BTL mortgages are typically interest only, and rents tend to be revised quarterly), while transport services is driven by fuel costs.

One slightly concerning outturn is the rise in accommodation services inflation, which we class as labour intensive. This mirrors the July rise in the sector in the Eurozone. Whether it is a one-off or a more long-standing issue remains to be seen.

Wage-Intensive Services Inflation Still Trending Down  

Taking this all together, wage-intensive services inflation rose slightly on the back of the rise in accommodation prices. It remains to be seen exactly what drove this rise, and whether it will last ahead. Hot July weather may have helped support demand for hotels, but until we get more months’ data it is all speculation. For now, our conclusion remains that the inflation momentum in wage-intensive services is fading, which should lower the need for the BoE to continue tightening.

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)