Monetary Policy  

Inflation slows more sharply than expected

Inflation slows more sharply than expected

The rate of inflation slowed slightly in July, hitting the Bank of England’s target of 2 per cent but undercutting expectations.

The consumer prices index including owner occupier’s housing costs (CPIH), measured in the year to July, was 2 per cent, lower than the 2.5 per cent seen in June as well as expectations, which were around a 2.3 per cent prices rise.

The rise was caused by increased spending on services since the re-opening of the economy on July 19, combined with a rise in savings during the pandemic which are now being spent.

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Inflation has overshot or hit the Bank of England’s 2 per cent target each month since May.

Daniel Casali, chief investment strategist at Tilney Smith & Williamson, said markets are now likely to price in a greater chance of the BoE hiking 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 dollar and euro,” he added.

Richard Carter, head of fixed interest research at Quilter Cheviot, said although in normal times an inflation rise of 2 per cent would set alarm bells ringing, markets and policy makers remain “relatively calm”.

“This is because policy makers – so far – have faith in the transitory narrative. They remain of the view that this bout of price increases will fade as the economy returns to normal. 

“But this is really a bluff. The inflation moderation is largely as a result of technical factors, primarily the fact that the initial surge in price increases during the early phase of the lockdown last year has now dropped out of the numbers.

“While it looks likely that inflation pressures will moderate as we head into next year and the economic bounce-back has had the chance to run its course, there is no doubt that the Bank of England will be itching to scale back its pandemic stimulus programme in the coming months.”

The transitory debate

The BoE has consistently told markets that it expects this inflation rise to be “transitory”, and whilst it may rise as high as 4 per cent by the end of the year, it does not intend to tighten policy “until there is clear evidence that significant progress is being made in eliminating spare capacity and achieving the 2 per cent inflation target sustainably”.

Tom Wells, the manager of Sanlam’s Global Inflation-Linked Fund, told a Sanlam inflation webinar on July 15 that “all inflation starts by being transitory - it has to come from a low base.”

He added although inflation may turn out to be stickier than first thought, central bankers “will continue to call it transitory in order to erode this debt pile and to ensure that we don’t pull support from the economy too soon.”