Another Month, Another Upside Surprise in UK Inflation – Is an August Rate Cut Still On?

Markets had been expecting the UK’s June CPI release to remain in line with the prior two months – holding at around 3.4% (y-o-y). Whilst not ideal in that these figures remain well in excess of the Bank of England’s 2.0% target, the overshoot is perhaps understandable given that energy price volatility and one-off tax hikes seem to be the main drivers. Furthermore, many other recent economic indicators (monthly GDP, employment, retail sales) all suggest a rapidly cooling economy. This should surely help take some of the pressure out of inflation, right?

Policy Missteps Have Contributed to Inflation Going In the Wrong Direction

Wrong. CPI exceeded everyone’s expectations to jump up to 3.6% (y-o-y) in June, the highest it has been in 18 months. Not only is the data moving in the wrong direction, the causes are bound to keep officials at the Bank of England up at night. Big increases came from the food and clothing components of the index, providing the clearest indication yet that firms are choosing to pass on the government’s recent tax and minimum wage hikes back on to consumers in full. Should this continue, a revival of 2023’s wage-price spiral could follow and reinforce this upwards inflationary trend, which is the last thing that the UK needs right now.

How Did Markets React To The News?

The immediate market reaction has, though, been slightly positive if anything. There was a modest revival in the pound as this data is likely to keep the Bank of England wedded to its ‘gradual and careful’ interest rate cut approach. Only a couple of days prior Governor Bailey had suggested that a more rapid fall in rates than this could be warranted should increased slack emerge in the UK economy. This exacerbated earlier pound losses instigated by the lacklustre monthly GDP release for May. The unexpectedly high inflation reading, however, seemingly rules out the prospect of an accelerated program of policy loosening for the time being, allowing the UK to maintain its rate advantage over its peers for longer.

The Implications for the Pound Are Mixed

Yet, in the longer-run this stubbornly high inflation trend is likely to prove to be a double-edged sword for the pound. Combined with ever-mounting debt concerns, the UK’s unique difficulty in shaking inflation adds to fears that the country lacks the ability to deal with its quite glaring deep-rooted economic problems, and is falling behind its rich-world peers as a result. This is undercutting the UK’s attractiveness to foreign investors, and limiting any potential rebound in the pound linked to the maintenance of a relatively tight monetary policy position.

Does This Mean An August Rate Cut Is Off the Table?

While the inflation figures were above expectations, they still may not be enough to deter the Bank of England from a modest 25bps rate cut to 4.0% on August 7. The jobs report released a day later provided further evidence of emerging slack in the economy - a prospect that Governor Bailey and others at the Bank are clearly concerned about. The MPC may therefore choose to look through these inflation figures (particularly the energy component of the data now that some semblance of normality appears to have returned to the Middle East) and instead focus its immediate policy response on lacklustre domestic growth drivers. Higher inflation risks are, however, likely to rule out the swifter program of rate cuts that had been alluded to by the Bank’s governor last week, and keep the current cadence of cuts to just one a quarter, if that. Price stability is, after all, meant to be the Bank’s primary policy directive.

Domestic Economic Factors Are Not the Only Things On Our Mind When It Comes To The Pound

Beyond that, the next major test for the pound will be the US Fed’s July 30 rate announcement. A hawkish response to June’s rise in US inflation - which provided the first evidence of the ‘Trump tariff effect’ on prices - could prompt the dollar to gain at the expense of other currencies. The pound could be particularly vulnerable due to the deteriorating domestic economic outlook and unstable political backdrop, with a government seemingly incapable of passing even the most straightforward reforms and cost-saving measures.

‘The Donald’ Can Still Change The Rules Of The Game In An Instant

Though, of course, we cannot discount the ‘Trump factor’. The biggest swing seen between the pound and the dollar last week occurred not because of any particular US or UK economic data release – it was because Trump openly mulled firing Fed Chair Jerome Powell to install a hand-picked stooge who will slash interest rates for him. While the refrain ‘Trump always chickens out’ (or the catchy ‘TACO’, for short…) may be holding for now – should he do the unthinkable then investors will have to rapidly re-evaluate every risk they are exposed to. In these circumstances, underlying economic drivers will play a back seat to politics when it comes to determining currency movements.