UK's June Inflation

The Office for National Statistics (ONS) had another surprise for the markets on Tuesday, this time it was the Consumer Price Index (CPI), which grew by 1.9 percent in the year to June 2014, up from 1.5 percent in May. The latest June CPI, an official measurement of inflation, is now hovering close to the Bank of England’s (BOEs) annual inflation rate target of 2.0 percent, so all bets are now on an imminent interest rate rise in the UK. Indeed, the market’s reaction to the surprising jump in June’s CPI figures was predictable; there was a flight of hot money into sterling in search of a higher return, thereby pushing the exchange value of the UK pound further against the USD to a session high of $1.7133. The UK pound also appreciated against a basket of other currencies. Moreover, the price of UK bonds fell sharply on the bond market as traders fled UK bonds in anticipation of a rate rise before the end of the year. So markets have now priced in an interest rate increase, from a record low, to 0.5% interest base rate by the end of the year. 

The latest June CPI figure, released by the ONS on July 15, confirmed that British inflation has now surged to a five month high last month. The main reason behind the sharp rise in the May to June inflation rate has been price increases in food & non-alcoholic drinks; however, the figure is now little changed on the year to June. A variety of product groups notably fresh vegetables, bread and cereals, contributed to the monthly inflation rise in foods. Also the price increases in clothing, particularly women blouses and shoes, also added to the rise in June’s inflation figures. The relatively good weather throughout the May-June period could have resulted in retailers deterring price discounts as the sector decided to cash in on the cloth shopping spree, brought about by the fine weather. Air transport also registered a big month to month hike in prices, according to the ONS. Air fares rose between May and June 2014. The movements were primarily driven by changes in fares on European routes, according to the ONS report. The ONO June CPI report also added, that prices in the housing, water, electricity, gas & other fuels sector continue to have the largest upward effect on inflation, which have contributed around a quarter of the total June CPI figure. Alternatively, motor fuels currently have a downward pull on inflation. Average petrol prices were around £1.30 in June this year compared with £1.34 a year earlier.

But the June CPI figure of 1.9 percent did come as a bit of a surprise for the market. A recent poll conducted by Reuters indicated that economist had forecasted a small rise of inflation to just 1.6 percent. However, the question puzzling economist is whether the June CPI figure is just a monthly blip or further evidence of the UK’s upward trajectory for inflation this year, which would also mark the end of Britain’s historic period of low interest rates. "It currently looks a very close call as to whether the Bank of England will raise interest rates at the end of this year or hold off until early-2015. Indeed, there will undoubtedly be many swings in interest rate expectations over the coming weeks and months," said Howard Archer, economist at IHS Global Insight.

Indeed, the common belief that economists can’t agree on anything important is probably more than ever relevant to them forecasting the UK inflation rate and interest rates. One school of thought is that the June CPI figure is merely noise and that reading too much into a monthly set of figures is really a distraction when trying to forecast the UK inflation trajectory. This reasoning may hold water, after all clothing and air fare prices are usually volatile and one month’s inflation data alone cannot completely change the overall trend. Adding support to this view was an official from the ONS who said that there were signs that the good weather last month may have deterred retailers from cutting prices. Elizabeth Martins, an economist with HSBC, also added that the clothing effect was likely to be smoothed out in July's data. 

Moreover, the recent data shows that producer costs continued to fall last month and that there was barely any rise in what they charged customers in the so-called "factory gate prices". There’s also unlikely to be any wage type inflation, as the latest figures on pay are widely expected to show wage rises continuing to lag well behind inflation, in other words falling in real terms. Furthermore, the steady appreciation in sterling since the beginning of the year will be lowering the price of imports, thereby exerting downward pressure on inflation. "In the near-term, inflation is likely to remain subdued with the producer price inflation figures highlighting a lack of pipeline price pressures while remarkably low wage rate numbers also point to little near-term inflation threat. The strength of sterling will also help limit the upside for inflation," said James Knightley, economist at ING Financial Markets.

But not all economists see it that way. Referring to June’s CPI data, Chris Williamson, chief economist at data specialists Markit said, "The news will further fuel expectations that the Bank of England will start raising interest rates sooner rather than later, with November looking the most likely month for the first hike," said Chris Williamson, chief economist at data specialists Markit. Apparently, Markit’s survey is showing activity picking up.

However, if housing prices cool down in the months ahead, then probably the CPI June figures are just a temporary blip on the radar, meaning that future inflation rates could be within the BOE inflation target of 2 percent and therefore, no interest rate hikes in 2014 would materialize. The likely fall in real wages, the appreciating pound, the spare capacity in the economy and the frail euro zone recovery may put a damper on future inflation figures. So maybe the market has jumped the gun in anticipating pending interest rate rises.