UK Inflation Exceeds Expectations Ahead of BOE Decision

May’s inflation figures in the UK were reported above expectations on Wednesday, June 21, remaining unchanged from the previous month's print at 8.7% on an annual basis, compared to the 8.4% expected. The higher reading is seen pressuring the Bank of England (BOE) and the UK government to take more action. 

The central bank will hold its rate decision tomorrow, Thursday, June 22, where it is widely expected to hike interest rates for the 13th time in a row. Further interest rate increases are seen exacerbating growing fears of a mortgage crisis in the UK, but the latest inflation overshoot could force the BOE to keep tightening.

Market Responds Cautiously 

The pound initially jumped higher after the CPI release on Wednesday, but gains quickly reversed over rising fears that the UK’s economy would stagnate. GBP/USD traded as high as $1.2785 in the immediate aftermath but has since subsided to a low of $1.2715 as of the time of the writing. On the other hand, EUR/GBP reached a high of £0.8591, having fallen to £0.8533 as of the time of the writing after the release. 

The results of the CPI data elevated the possibility that the BOE could quicken the pace of its interest rate hikes. Following the data release, investors started to see around a 50% chance that Thursday's rate decision could result in a 50 basis points hike instead of the 25 basis points expected before the release. Markets are now pricing in interest rates peaking at 6.0% in 2023, above the 4.5% currently. Economists believe that officials will raise rates to at least 4.75% at the next BOE meeting on Thursday.

The CPI Figures in Detail

CPI inflation in Britain has remained more persistent than in other major developed economies, having the highest rate in the G7 countries. The number for May Core inflation, which the BOE uses as a guide for underlying price pressures as it excludes the volatile items of energy and food, rose to 7.1% from 6.8% in April. The Core print exceeded expectations of remaining unchanged, rising above the 30-year high it recorded last month.

The Office for National Statistics (ONS) in the UK pointed to increasing flight prices, recreational goods and services, and used car prices as the main culprits for pushing inflation up to historically high levels. In the opposite realm, the ONS noted that the most significant downward pressure came from gas (NG) prices.

What Could It Mean for BOE's Meeting

Before the release of the inflation data, the Bank of England was already expected to hike by a quarter of a point. Wage data had already raised market expectations, with markets already pricing in a terminal rate of 6% in the coming months. Economists pointed to a disagreement on the interpretation of whether inflation would be persistent due to second-round effects from energy or that inflation would eventually come down thanks in part to base effects.

Following the data, analysts started to point to a recession as a means to get inflation back down. On the other hand, traders piled into the markets to price in rate hikes reaching 6% by December and set up a 50-50 chance of a "double" rate hike at tomorrow's meeting. Even those who think a 50 basis points hike is unlikely to suggest that a minority vote could favour hiking more than 25 basis points. Economists are also expecting the messaging from the BOE to be more hawkish.

Beyond the Next Meeting

The market reacted negatively to the inflation news, with effects seen outside the UK. The higher inflation reading was seen as a reminder that major central banks have more to do to bring down inflation. For example, the most sensitive bond rate in Europe to changes in rate expectations, Germany's two-year government bond yield, hit the highest since the beginning of March.

The sticky inflation and tight labour market have led many economists to increase their expectations for peak interest rates and now see the monetary tightening cycle lasting longer than expected. Following the data release, UK Chancellor of the Exchequer (Finance Minister) Jeremy Hunt doubled down on the government's plan to halve inflation by the end of the year, pledging support for targeted measures to deal with the cost of living. But, analysts point to inflation being driven more by supply issues; UK consumers have held up reasonably well in the cost-of-living crisis, but interest rates are now beginning to hurt households. Soaring mortgage costs are seen as potentially squeezing consumer spending along with higher taxes, with the BOE now facing a balancing act of bringing inflation down without inciting a mortgage crisis and recession. (Source: CNBC)

Conclusion

UK inflation came in higher than expected, with the core rate rising to a new 30-year high. Markets were already anticipating a quarter-point rate hike out of the BOE when it meets on Thursday, but the latest data now implies a 50% chance of a half-point rate hike. 

The UK is increasingly an outlier among major economies with its high inflation as the BOE is faced with a looming mortgage crisis from increasing interest rates. Many traders may have their eyes pinned on how long consumers can abide by higher interest rates as the tightening cycle appears to continue for longer.