UK interest rates expected to hit 6% after shock rise in core inflation – business live | Business

City economists say that another interest rate rise tomorrow is a done deal – the only question is whether the Bank of England plumps for a quarter-point rise in rates, to 4.75%, or goes big with a half-point rise to 5%.

The Bank has already raised interest rates 12 times since December 2021, but will not be happy that inflation is still so high.

Capital Economics are now predicting that the Bank will go for the half-point rise, to 5%, due to this morning’s inflation report. They cite the increase in core inflation, saying:

A lot of attention has focussed on the fact that inflation failed to fall in line with expectations last month and was instead unchanged at 8.7%. But the bigger concern in our view is that core inflation rose yet again, hitting a 31-year high of 7.1%.

This marks the UK out from other advanced economies, including the euro-zone and the US, where core inflation has started to fall. There are several factors at play, but an important one is that inflation appears to have infected the labour market and wage setting to a greater extent in the UK than elsewhere.

While tomorrow’s MPC meeting is finely balanced, we think that a 50bps increase in Bank rate is now slightly more likely than a 25bps. The consensus remains for a smaller increase, but the markets are pricing in a 50% chance of larger move. Accordingly, a failure to deliver could cause financial conditions to loosen and the pound to weaken, which is the last thing that policymakers at the Bank need right now.

Analysts at ING say the Bank of England faces a very difficult dilemma, but suspect rates won’t reach 6%, as the markets are now pricing in.

Headline inflation should come down more noticeably over the next couple of months, owing to some pretty hefty base effects. Last June saw a near 10% spike in petrol prices, whereas prices are currently falling, and of course in July we’ll see a material fall in household electricity/gas bills. Core inflation we think should come lower too, though to a much lesser degree and mainly because of further renewed downward pressure from certain goods categories.

Headline CPI, we think, will be just below 7% by July and around 4.5% by year-end. Core inflation will probably end the year above 5%.

All of this makes life even harder for the Bank of England. We think the bar for another 50bp hike is set pretty high, but a 25bp hike is basically guaranteed, as is another in August. But markets are now fully pricing a 6% peak for the Bank rate, which implies six more rate hikes from current levels. That seems excessive, and we suspect the Bank of England would privately agree.

Chancellor Jeremy Hunt has said the Government would “stick to its guns”, after inflation remained higher than hoped in May

He told broadcasters:

“Today’s figures strengthen the case for the Government to stick to its guns.

“No matter what the pressure from left, right or centre, we won’t be pushed off course.

“Because if we are going to help families, if we are going to relieve the pressure on people with mortgages, on businesses, we need to squeeze every last drop of high inflation out of the economy.”

Hunt has also called for patience, while rising interest rates have their effect on prices, saying:

“If you look at what’s happening in other countries, you can see that rises in interest rates do bring down inflation over time.

“That will happen here but we need to be patient, we need to stick to the course and then we’ll get to the other side.”

City investors are ratching up their expectations for Bank of England interest rate rises, following the shock rise in core inflation.

The markets are pricing in that UK interest rates will hit 6% by December, up from 4.5% today.

Traders are concluding that the BoE will be very concerned that underlying inflation, and service sector inflation, both rose in May.

The odds of a half-point increase tomorrow, when the Bank next sets interest rates, has now jumped to over 40%, according to the price of interest rate swaps.

Before the inflation data was released, such a 50-basis point hike tomorrow was seen as a 25% chance.

Jake Finney, economist at PwC says:

UK inflation has once again come in higher than expected at 8.7% in May. This is higher than the 8.5% consensus and the Bank of England’s forecast of 8.3% in May. More troublingly, core CPI – which is considered to be indicative of underlying inflation pressures – unexpectedly increased to 7.1%.
The primary culprit for the higher headline figure was services inflation, which increased from 6.9% to 7.4% due to upward pressure from cultural services. It now seems likely that services inflation will take longer to come down than the time it took to come up, especially with wage growth remaining strong.
Higher inflation means that the squeeze on household incomes isn’t over yet, despite strong wage growth. It also cements a rate hike from the Bank of England tomorrow and means an August rate hike is now more likely than not.

Food price inflation has eased in May, but products still cost much more than a year ago.

The inflation rate for food and non-alcoholic beverages dropped to 18.3% in the year to May, down from 19% in April.

During May alone, food and non-alcoholic drink prices rose by 0.9% between April and May 2023, compared with a larger 1.5% increase between the same two months a year ago.

Helen Dickinson, chief executive of the British Retail Consortium, says:

“It is a really positive sign that food inflation has fallen for the second consecutive month, the first time this has happened since the Ukraine war began.

While some prices continue to rise, we are now seeing regular news reports of falling prices on many essential products, such as loo rolls and vegetable oil. It has been good to see larger drops in inflation rates for flour, milk and eggs as retailers continue to invest heavily in lower prices for the future and locking the price of many essentials, helping the UK to deliver some of the cheapest groceries in Europe.

Elsewhere, consumers will find themselves under pressure from increased health and communication costs, as inflation rates in both categories rose in May.

Grant Fitzner, the chief economist at the Office for National Statistics, says rising wages are fuelling the worrying increase in core inflation in May, to 7.1%.

Speaking on Radio 4’s Today programme, Fitzner confirms that headline inflation rate was unchanged in May at 8.7%, but adds:

In terms of what’s under the bonnet, something that may cause some concern is the continuing rise in core inflation.

That excludes food, energy, alcohol and tobacco, which has risen to 7.1%, the highest annual rate in core inflation since March 1992.

Fitzner explains that while goods inflation has been heading downwards, prices in the services sector – such as at cafes, restaurants and hotels – are rising at a faster pace.

That lifted services sector inflation to 7.4% (from 6.9% in April), which is the highest rate “in quite a while”.

This increase is probably driven at least in part by increases in wages, Fitzner suggests. [data last week showed regular pay increased by 7.2% in the three months to April, a 20-year high].