The UK has experienced its first inflation increase of the year, with the Consumer Price Index (CPI) rising to 2.2% in July. This development, however, is less a cause for alarm and more a signal that the economy may be transitioning back to more typical fluctuations after nearly three years of erratic price movements.
The latest inflation data suggests that the wild volatility experienced in the wake of the COVID-19 pandemic and the energy crisis might be easing, paving the way for a more stable economic environment.
The primary driver behind July’s inflation rise is the so-called "base effect," particularly concerning energy prices. In July 2023, energy prices saw a significant reduction due to a substantial fall in the Ofgem retail price cap by over £1,100. In contrast, last month’s reduction was a much smaller £110. As a result, although energy prices remain lower than they were a year ago, the annual inflation rate has increased.
The Bank of England had already anticipated this modest inflationary rise, using it as a basis for its cautious approach towards interest rate adjustments. Earlier this month, the Bank cut interest rates for the first time since its aggressive hiking cycle began, indicating that while inflation is rising, it remains under control and within the Bank's expectations.
Interestingly, goods inflation remains in negative territory at -0.6%, although this represents an increase from -1.4% the previous month. This shift is partly driven by food inflation, which has risen to 1.8% after 15 consecutive months of decline. On the other hand, inflation in the services sector, which constitutes the majority of the UK economy, fell to 5.2%. This decline, coupled with a recent easing in wage inflation, has bolstered market expectations for further interest rate cuts in the near future.
Market sentiment is currently mixed regarding the Bank of England's next steps. While there is a 45% chance of a rate cut in September, the likelihood of rates being held steady at 5% is slightly higher. However, there is a strong consensus that further rate cuts are likely before the end of the year, with a 90% chance of a reduction in November and a 97% chance in December.
While the rise in inflation may raise some eyebrows, it is largely a return to more normal economic patterns. The Bank of England’s measured response and market expectations suggest that the path ahead, while uncertain, is under careful scrutiny, with the potential for more favourable economic conditions on the horizon.
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