Inflation likely to remain very low in coming months despite increase in July

UK CPI inflation increased to 0.1% y/y in July, from 0.0% y/y in June (Danske Bank 0.1% y/y, consensus 0.0%). The small increase in CPI inflation was due mainly to the timing of summer sales last year, as prices fell in July instead of June last year. Core inflation was 1.2% y/y in July, which was higher than expected (Danske Bank 0.9% y/y, consensus 0.8% y/y).

The Bank of England’s (BoE) focus appears to have shifted back to inflation in the wake of lower oil prices and stronger sterling. We expect CPI inflation to stay very low for the rest of the year and then pick up in January but the lower oil prices, energy bill price cuts and strong sterling imply that the pickup will be smaller than previously expected. Also, we cannot rule out inflation turning negative in coming months. Thus, the inflation prints in coming months will be much more important than today’s release.

We think the BoE wants to see CPI inflation stabilise/move higher before hiking and hence most MPC members are unlikely to feel comfortable with the near-term inflation outlook. The pickup in January should reduce concerns and thus we expect the BoE to deliver the first hike in Q1 16, probably in February (previously November 2015).

Looking at the details, ‘clothing and footwear’ pushed the inflation rate up by 0.2pp, which, as mentioned, is a result of the timing of the summer sales in 2014. This is more than we had expected. This is also the main reason core inflation picked up more than expected. There were smaller upward contributions from ‘transport services’ (mainly air fares), ‘recreation and culture’ and ‘miscellaneous goods and services’. Core inflation in August is likely to fall slightly as the base effects of the timing of summer sales fall out; hence, the surprisingly high core inflation in July should not be over interpreted.

Food prices continued to decline and lowered the inflation rate by 0.1pp. There were also small downward contributions from ‘fuels and lubricants’ and ‘restaurants and hotels’, as prices for these two components did not increase as much as last year.

Services inflation increased to 2.4% y/y in July, from 2.2% y/y in June. This is low from an historical perspective but still above the BoE’s 2.0% target. It is important to remember that services prices are more domestically generated than other components. Services inflation above 2% would be likely to make the BoE confident about raising rates in February despite headline CPI inflation being subdued.

EUR/GBP declined and GBP/USD increased following the release. We still think EUR/GBP downside potential is likely to be limited due to low inflation, while GBP/USD is likely to decline on possible USD strength. We target EUR/GBP at 0.70 in 3M and GBP/USD at 1.51 in 3M.

See the following page for illustrative charts.