News & analysis

Headline inflation dropped to 2.0% in May, returning to the Bank of England’s target for the first time since July 2021. Despite this, however, the details of today’s inflation report suggest that a degree of caution is still warranted from the MPC.

Core inflation remains some way above target and services inflation overshot Bank staff projections for the second month in a row. All told, this points to underlying inflation pressures that remain stickier than expected by policymakers back in May, albeit this is also consistent with our view that the April rise in the National Living Wage would see both pay growth and inflation tracking temporarily above BoE forecasts. We expect this impulse to fade markedly in next month’s data, which should keep the MPC on track to ease rates in August, in line with our base case.

For now though, markets are taking a hawkish read through on this latest set of prints, modestly pushing back easing expectations in advance of tomorrows policy meeting.

Looking through the details of today’s report, the data tells a broadly similar story to the headline figures. Unsurprisingly, food and energy costs were a notable drag on price growth last month. Food, alcohol and tobacco rose by just 3.3%YoY in May, down from 4.2% in April, while base effects saw the annual change in energy prices sink by -15.9% YoY. Stripping out these volatile components, core CPI growth dropped from 3.9% to 3.5%, in line with market expectations. This however hides a notable divergence that should be cause for some consternation across the MPC tomorrow. Overall goods inflation is now at -1.3%YoY down from -0.8% in April, having flatlined last month. Services CPI, however, overshot pre-release estimates to land at 5.7% YoY, 0.2pp lower than April but 0.2pp above consensus projections and 0.4pp above Bank staff forecasts.

Moreover, the upside surprise in services price growth appears relatively broad based, with few standout upside contributions to explain this latest overshoot.

It is notable to us though, that where there are pockets of inflationary strength, they are concentrated in typically low paying sectors. Restaurants and hotels for example saw prices rise by 5.8% last month, only fractionally down on the 6.0% seen in April, with MoM price growth of 0.7% in May alone. This is consistent with labour market data that has also seen notable signs of sticky wage pressures across a number of these sectors too, suggesting to us that at least some of April’s rise in the NLW is being transmitted to consumers.

Looking ahead, Bank staff had projected that headline inflation would print at 2.0%YoY next month, with services inflation expected to fall to 5.1% in June.

The former looks reasonable to us given today’s figures; the latter seems like a long shot. Even so, we do expect next month’s services inflation print to be much closer to Bank staff forecasts that today’s figures managed. Our long-standing call has been that the NLW rise would temporarily see wage and inflation data surprise to the upside across the March, April and May data, given the technical details of how the wage increase is implemented. This impulse should begin to fade from next month if we are correct, meaning that the BoE should receive a more benign inflation print in advance of the August policy meeting. As such, we retain our call for the MPC to begin easing policy in August for now, but risks look increasingly skewed towards a later start to easing, possibly in September. A key test of this thesis will come tomorrow. If the MPC shares our view, then they should be content to run back the messaging from the May meeting. But there are now clear risks that policymakers will want to see multiple good data prints before starting to ease policy, weighing in favour of more hawkish messaging. Given this, traders are paring their easing expectations post-release. The implied odds of an August rate cut have fallen from 50% to 40%, a move that has seen sterling rally two tenths against both the euro and the dollar.



Nick Rees, FX Market Analyst


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