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Tilney Smith & Williamson comments on July CPI inflation data

On the back of the release of July UK CPI inflation data, Daniel Casali, Chief Investment Strategist at Tilney Smith & Williamson comments:

 What happened?

UK July annual headline CPI inflation came in at 2.0% (consensus: +2.3%) against 2.5% in June. Core CPI inflation (excluding energy, food, alcohol and tobacco) was 1.9% (consensus: 2.2%) versus 2.3% in June. While unfavourable base effects from a year ago led to a slowing in the annual July CPI inflation, the risk of a higher future inflation rate remains tilted to the upside.

First, as the economy is reopened from social distancing rules that were largely removed on “Freedom Day” on 19 July, expect a rotation in consumer spending towards services over goods. Greater demand, as well as rising wage growth in the leisure and hospitality sectors, will continue to exert upward price pressure in services and push-up overall inflation. In July, services CPI inflation accelerated to 1.6% from a record low of 0.6% in August 2020.

Second, firms have room to raise prices as sectors are reopened. Household savings remain elevated giving consumers the financial wherewithal to spend and a supply-squeeze caused by the pandemic has boosted company pricing power. Businesses have already signalled their intention to raise prices in the latest CBI industrial trends survey, where 42% of respondents expected the price of domestic orders to rise in July. This is the second highest reading since 1984, after a 46% response in June.

Third, energy continues to remain a source of inflation. The lifting of Ofgem’s (the UK’s gas and electricity regulator) price cap and rising crude oil prices from a year ago are adding to overall annual inflation.

Fourth, further upstream price pressures are building in producer prices data. In July, underlying output Producer Price inflation (excluding food, beverages, tobacco and petroleum products) rose 4.9%, the highest rate for a decade.

What does it mean?

With UK inflation exceeding or at the BOE’s 2% inflation target for the third consecutive month and recovering economic growth, the market is likely to price in a greater chance that the central bank will raise interest rates over the next 12 to 18 months. Given an expected hawkish tone to be taken by the BOE against its major counterparts, like the Fed and ECB, there is room for sterling to appreciate against the USD and euro.

An argument against BOE interest rate increases is that the unemployment rate rises as the government’s job furlough scheme is scaled back. However, that looks a low probability. The Office of National Statistics showed that as 800k workers came off the furloughed scheme in July, business payrolls registered a strong gain of 182k and job vacancies rose to a record high of 953k for the month. This indicates that many furloughed workers remained with their existing employer or found new jobs. Either way, the risk of a spike of the unemployment rate that delays a BOE rate hike over the next year has lessened.

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