Inflation retreats in the UK, but for how long?

Price action in the major markets has stabilised somewhat in the middle of the week, after some steep losses for stocks on Tuesday. S&P 500 E-mini futures are predicting a small decline of 0.7% on Wednesday, bond yields are continuing to move higher, which could dent risk sentiment in the second half of this week. There does not appear to be a unified consensus about what the Federal Reserve and other major central banks will do next. This is having a knock-on effect of causing volatility to rise, which is hitting the performance of global stocks. As we move towards the end of the summer, weakness in China, alongside the next move from the major central banks are the key themes to watch out for. In the UK, inflation fell as expected in July, however, the future path for price growth is less clear.

Looking at the UK inflation report more closely, headline price growth fell 0.4% on the month in July, and it dropped to 6.8% from 7.9% in June. This decline was expected, although the monthly fall in prices was slightly less than the -0.5% expected. The July inflation figures were easy to predict, largely because of the changes to the energy price cap compared to a year ago. It was not all good news on the inflation front, core price growth rose to 6.9% YoY from 6.8% in June. Also, producer prices are creeping higher. PPI core output prices, which are a large contributor to CPI prices, rose 0.1% on the month, and jumped from 1.6% YoY in June to 2.3% in July. Falling gas and electricity prices made the largest contributions to the fall in inflation, and food price growth slowed compared with June. Hotel and air travel contributed to inflation growth in July. Clothing prices fell last month, however, there are concerns that they could turn higher, after stronger wage growth for the three months to July, and the better weather in August. Service price inflation also edged higher last month to 6.5% Yoy from 6.3% in June.

Overall, the deflationary trend is settling into the UK, albeit at a delayed rate compared to our peers, especially the US. The spread between inflation in the UK and the G20 is 220 bps, which still leaves the UK as an outlier, however, it is at its lowest level for 11 months. Added to this, there are expected to be further declines in the energy price cap next quarter, thus, we could see this spread narrow further in October.

The stubbornly high rate of core inflation has hogged the headlines on Wednesday; however, more timely data suggests that the core rate of inflation is modifying, but it may take some months to see it in the annual comparison data. For example, 3-MoM inflation trends suggests that price growth is now 0.4% MoM, which is a large decline compared with price growth of well over 0.5% for most of this year. Thus, a deflation trend is in place in the UK, although it doesn’t seem to grab the media’s attention, and yet again UK bond yields are higher. The 10-year yield is currently up 3 basis points on Wednesday, and this is hurting the FTSE 100, which is down more than 0.5% in the middle of the week.

Inflation and wage growth may have dominated the UK’s financial headlines this week, but it’s always worth challenging the data and the prevailing narrative, for three reasons, as the technical make-up of the data could be creating a misleading picture of UK price growth.  

1, Food price growth in the UK appears to be levelling off, however, food price inflation is probably a lot less than what is being reported. Supermarket loyalty programmes give their members hefty discounts; however, these discounts are not applicable to those without loyalty cards. Hence, most people have loyalty cards, otherwise going into Tesco’s without your Clubcard is a bit like buying your groceries in Harrods! However, the ONS does not include discounts that are only applied to loyalty card holders in their calculation for CPI. In the US they do, and most of Europe does not have a loyalty card system like the UK. Hence, there is a strong argument that UK food inflation is being overstated.

 2, Wage growth: UK wage growth rose to 7.8% YoY between April and June, and this does not include the recent agreement to boost wages for large swathes of the public sector. The story was that 7.8% is the highest growth rate for regular pay since records began in 2001. However, what it doesn’t account for is the containment of wages from 2008- 2020, and the fact that this calculation uses average wage growth. This means that if lower earners are not getting a pay rise, this does not show through in the data, as the higher earners’ wage growth keeps the average rate elevated. Thus, wage growth in the UK could also be elevated.

3, As mentioned above, the 3-month growth rate in inflation has fallen sharply, however, because we measure inflation on an annualised basis, it could take some time for this to show through in the data.

Overall, price growth in the UK is high, but it may not be as high as expected. How stubborn inflation will remain will depend on what your thoughts are about supply in the economy: goods supply continues to ease, labour supply remains tight, although the claimant count rate rose in July and the unemployment rate jumped from 4% to 4.2% in June.

This makes for a very interesting Jackson Hole central bankers symposium later this month – will central bankers be able to say that the peak for rates is nigh due to encouraging shorter term trends in inflation? We shall have to see. In terms of price action, stocks are lower, and FX is mixed. EUR/USD is lower again today and is clinging to the 1.09 handle, after a very weak ZEW in Germany earlier this week, which may put pressure on the ECB to halt its rate hikes. GBP/USD is stronger after the rise in core inflation, however, once the dust has settled and more FX traders see the light when it comes to inflation and what is being reported vs. the reality of inflation in the UK, then we could see any pound strength start to fade. $1.30 looks like a stetch to us in this environment. Brent crude is higher again and is pushing towards $85 per barrel, however, with weak China economic data and no stimulus in sight, it is hard to see how the party for oil will continue into the Autumn.