August cut hopes fade despite BoE’s inflation bullseye

The latest UK inflation figures will bring some relief for consumers, but beneath the headline figure the Bank of England’s (BoE) policymakers face a more complex picture that suggests interest rate cuts may still be some way off.

Data published on Wednesday morning showed Consumer Price Index (CPI) inflation dropped to exactly 2.0% in May, in line with market expectations and marking a return to the BoE’s 2% target for the first time since July 2021.

Key figures:

• CPI inflation: Fell to 2.0%, matching the consensus and slightly above the BoE's forecast of 1.9%
• Core CPI inflation: Fell to 3.5%, in line with market expectations
• Services CPI inflation: Fell to 5.7%, above market expectations of 5.5% and the BoE's forecast of 5.3%

The drop in headline inflation to the target rate is a positive development, especially considering UK inflation peaked at 11.1% in October 2022, at which time it was hard to believe the BoE would beat the Federal Reserve and European Central Bank in returning inflation to target. The fall was largely driven by significant declines in non-energy industrial goods and food prices; used car prices fell 0.5% versus the previous month, for example, while annual food price inflation fell to 1.7% in May from 2.9% in April.

However, services inflation remained stubbornly high at 5.7% in May, only a slight decrease from previous months and materially higher than the BoE’s forecast of 5.3%. This persistence is primarily due to unexpected increases in airfares, accommodation, and communication costs. Airfares alone surged 14.9% month-on-month, much higher than anticipated and accommodation prices also rose more than expected.

Prior to Wednesday’s CPI data markets had largely dismissed any chance of a June rate cut from the BoE, though the probability of an August cut sat at 44%. Following the data release, which did little to alleviate concerns about high wage and services inflation, the reaction in gilts has been fairly subdued. Two-year gilts yields rose by 5bp and 10-year gilts by 3bp, but rate cut expectations have also been scaled back with markets now reflecting a 36% chance of an August cut and a total of 42bp worth of cuts by year-end.

Despite the BoE's achievement in bringing headline inflation down to the 2% target, the stickiness of services inflation, which is driven by robust wage growth and resilient demand in certain sectors, makes an August rate cut increasingly unlikely in our view. Inflation is expected to hold steady at 2.0% in June but could rise to 2.9% by November (as forecast by Pantheon Macroeconomics) due to a potential rise in the UK’s utility price cap to reflect the rise in wholesale energy prices. Achieving a sustainable return to the 2% target hinges on significantly reducing services inflation, which is only projected to decrease to 4.8% by the end of 2024. This highlights the challenge of holding inflation to the 2% target and reinforces the BoE’s data-driven approach as the appropriate strategy moving forward.

Prime Minister Rishi Sunak and the Conservative Party may celebrate the return to 2% inflation and advocate for rate cuts, but the persistence of services and wage inflation we believe removes any chance of an August cut. The recent increase in unemployment to 4.4% in April may point to some economic softness, but it may not be enough to move the dial in the BoE’s decision-making process.

While the improvement in the headline rate is notable, the path to stable, low inflation remains complex. We expect the BoE to proceed cautiously and delay any rate cuts until there is more consistent evidence of declining inflationary pressures across all sectors.