While favourable base effects and idiosyncrasies from Ofgem energy price cap will likely drive headline CPI to 2% target in the next few months, a bounce back is likely.
Food inflation is still a problem and core inflation, which strips out volatile food and energy prices, is not showing reliable signs of falling. Meanwhile, services are still running hot driven by strong wage growth. It will take a prolonged period of higher rates to bring services activity back to levels consistent with the 2% inflation target.
It is therefore not yet clear the underlying causes of inflation are vanquished, especially given continued tightness in the labour market. As the year progresses favourable base effects will diminish, and we could even face a second round of higher inflation, especially if the US economy stays strong, which would serve to limit the Fed’s rate cuts and cement dollar strength.
The BoE can cut before the Fed, but it will feel limited in how far it can go if the US doesn’t follow suit. It will therefore view the latest relatively weak US payrolls data as something of a relief. It’s a sign that the lagged effect of higher interest rates is finally taking its toll on the American economy and that Fed policy will be reasonably aligned with other central banks.
Central banks set the stage for cuts
It’s relatively straightforward to conclude the ECB goes early and the Fed late in terms of cutting interest rates. Inflation is under control on the continent and the problem is growth. For the US it is the other way around. Growth is robust, led by a confident consumer, but inflation is sticky. The UK is somewhere between the two, but it is unclear where it lies on the spectrum. The economy has returned to growth after a shallow technical recession but is still lacklustre. Zooming out to the bigger picture, it is likely to continue to tread a steady but underwhelming path.
The mixed economic picture, a unique inflation problem and unreliable employment data make BoE’s decision making difficult. Overall, MPC members are likely to vote on balance to hold rates at the current level for both May and June but the votes for a cut will increase.
When will interest rates fall?
The first reduction in UK interest rates from 5.25% will probably occur in August and there could be one, maybe two, further cuts this year. This will be seen from the BoE’s point of view as moderately restrictive still, and an appropriate balance given the need to both ensure the downtrend in price rises continues and provide a platform to cut more quickly in the event of an economic slowdown.
The Bank will want to see a more substantial cooling in wage increases, and in more sticky services inflation, before reducing rates. Although the economy is hardly rocketing it has been strong enough to keep things tight, helping maintain upward pressure on prices.
