Examining the Inflation Outlook: Anticipating a Summer Turnaround and its Impact on Bank of England's Monetary Policy

The inflation story should start to turn over the summer

Then there’s the inflation data itself. The dividing line on the committee right now seems between those hawks that are seeing persistent ‘second-round effects’ of higher energy/food prices, and the doves that think headline/core CPI is simply just lagging behind the wider fall in input and product price inflation over recent months (see a speech by BoE’s Dhingra).

Elements of both are true. April’s CPI figures were undeniably ugly, though some of the drivers – higher vehicle and alcohol prices, for example – are unlikely to form long-lasting trends. We agree with the doves that food inflation should begin to ease back in line with producer prices, while services inflation (particularly hospitality) should come under less pressure now gas prices are so much lower. The BoE’s own Decision Maker Panel survey of chief financial officers suggests pay and price expectations have also eased noticeably over recent months.

If nothing else, hefty base effects should ensure that the headline inflation rate comes down over the summer months and fluctuates around 6%, and to a lesser extent the same is true of the core rate.

Barring some further unpleasant and consistent surprises in the services inflation figures over the coming months, we think a 5% peak for Bank Rate seems reasonable. That implies rate hikes on Thursday and again in August. 

However, as we discussed in more detail in a separate piece, we think the downtrend in wage growth is going to be slow – even if it has probably peaked. Labour market shortages look at least partly structural, and we suspect wage growth could end the year above 5% (7% currently). While that doesn't necessarily require the Bank to take rates much higher, it does suggest rate cuts are unlikely for at least a year, not least given the mortgage market structure discussed earlier.

 

Sterling trade-weighted index pushes back to early 2022 highs

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Sterling can hold onto gains in the near term

Sterling continues to ride high. On a trade-weighted basis, it is returning to levels last seen in early 2022 before Russia's invasion of Ukraine. Barring a surprisingly soft May UK CPI on Wednesday, 21 June, it looks like sterling can largely hang onto those gains if the Bank of England does not push back against very aggressive tightening expectations.

Our strong preference has been that sterling will enjoy more upside against the dollar than the euro. Currently, we have a 1.33 end-year forecast for GBP/USD and the near-term bias is for 1.30 given what seems to be bearish momentum building against the dollar.

EUR/GBP has been weaker than we had expected. And next week's BoE meeting may be too soon to expect a bullish reversal here. Yet, consistent with our house view that the Bank Rate will not be taken as high as the 5.65% level currently priced by investors for the end of this year, we suspect that EUR/GBP ends the year closer to the 0.88 area, meaning that current EUR/GBP levels should make a good opportunity to hedge sterling receivables for euro-based accounts.