April’s inflation print throws a spanner in the works as the bird watch continues

PS General Election incoming

Rishi Sunak’s announcement of an election came as a major surprise to most Westminster observers but financial markets were unmoved by the news. Political risk in the UK is minimal at the moment: market participants expect a new government after July 4 and are unconcerned by it. Globally, there is no doubt that there could be major market-moving public policy changes – not least in the United States later this year – but we are unlikely to see such changes in the UK.

Turning to the latest from the Bank of England, since the last Rate Wrap, we’ve had both an interest rate decision and a new inflation report from the Bank of England. While base rate was held as widely expected, the collective positioning of the Monetary Policy Committee on rate cuts continues to pivot in a dovish direction. Dave Ramsden joined Swati Dhingra in backing a rate cut, leading to a 7 to 2 split on the committee in favour of holding rates. Moreover, the BoE’s new inflation forecast under the assumption that market expectations for interest rates are followed, suggests that inflation will be below 2% by 2026. This is an important signal from the BoE as it suggests its current view is that market expectations for interest rates are too hawkish. Add to this that the UK’s inflation is now notably lower than that in the US, and all the signs were pointing towards a relatively smooth road towards a summer interest rate cut.

However, April’s inflation print has thrown a major spanner in the works. Inflation dropped quite considerably from 3.2% to 2.3%, sitting very close to the Bank of England’s inflation target, but this was above expectations and, crucially, this “upside surprise” was driven by services inflation being stubborn. Markets expected a fall of 0.6pp in y-o-y services inflation but in the event it barely budged and now sits at 5.9%, which remains far higher than the level compatible with the bank’s inflation target in the medium term. Rate setters are scrutinising services inflation especially closely at the moment given how highly influenced it is by wage costs. The bank’s most recent estimates suggest that elevated wage costs are contributing to over four fifths of services inflation. And that, of course, signals signs of persistence in inflation, which may currently be exacerbated by the circa. 10% increase in the National Living Wage that entered into force in April.

This upside surprise to inflation means that a rate cut in June is all but off the table. Before April’s inflation data, markets thought it was a coin-flip as to whether there would be a cut in June; now it is being priced at just a 15% chance (as of 22.05). Of course, it is possible that upcoming data releases could change the calculation once again – there will, after all, be further labour market and inflation figures before the June rate decision – but it would seem unlikely that the data will see enough of an improvement to encourage a further three MPC members to back a rate cut in June.  

The first rate cut of this cycle will mark an important moment as it will no doubt help to improve confidence in the UK economy. It is, course, notable now that the June MPC decision will come during the middle of a general election campaign, but the Bank of England will want to ensure that none of its actions could be construed as interfering in the political process and will continue to focus on the data. Our current view is that the direction of travel is for a rate cut in August, although the reaction to April’s inflation figures highlights just how sensitive markets and the MPC are to individual data releases at the moment. So prepare for further surprises along the way… 

Daniel Mahoney, UK Economist

The bird watch continues after the Bank of England met earlier this month, voting for a 7-2 hold. The key takeaway was Deputy Governor Dave Ramsden joined the dovish bench alongside Swati Dhingra at this month’s meeting. Mr Ramsden has often been the bellwether for where the committee looks to be headed next, with examples of this being November 2021’s meeting where he voted for a hike, with the majority following suit in December, and the same story in February and September 2022 meetings. Market pricing moved after the meeting with a cut now fully priced back into August. 

The devil in the detail

Taking a magnifying glass to the guidance issued after the MPC’s meeting shows a slight shifting focus to the array of data releases over the course of the month and before the 20 June meeting. Without any large surprises on the upside, the guidance points to a summer cut, with language suggesting that the committee is close to cutting rates, but wants to keep an eye on inflation persistence and pay before sealing the deal. With all this in mind, it seems that the data isn’t playing as pivotal a position in market pricing as the MPC language is, and markets were pricing in a 60% chance of a rate cut in June, with a cut fully priced in for August. MPC member Megan Greene notably commented that we are in “the last mile”, and the key in this messaging is not a case of how much longer we will have tighter monetary policy, but more close we are to a cut. The continued dovish tones put a summer cut firmly on the roadmap.

However, this narrative has quickly shifted, as the April inflation print came in hotter than expected at 2.3% YoY CPI, against 2.1% market expectations as Dan explains above. Likewise, services inflation continues to print hotter, coming in at 5.9% against March’s 6% figure. Services inflation remaining stubborn is weighing down on market expectations for a rate cut in the immediate aftermath, a far cry from early May’s 60% June cut expectation. Some MPC members have been hinting at services inflation needing to be 3%, and April’s reading has missed MPC forecasts by 0.5%. The hotter reading has pushed out rate cut expectations and markets have reacted in knee-jerk fashion. In the immediate aftermath of the reading markets have all but priced out a cut for June (only an 11% chance), and fully priced in the first cut for November. We think this is slightly overdone, and pricing could move more in line with the US to put a September cut on the radar, which is in line with our Global Macro Forecast Opens in a new window.

UK pay figures released for Q1 2024 surprised slightly on the upside with annual earnings growth excluding bonuses printing at 5.7% (surveyed 5.5%), with the highest pay growth in manufacturing, finance and business services. The ongoing challenges around the reliability of the Labour Force Survey still weighs on data integrity due to low response rates, and so the ONS figures are likely to be the focal data point for the MPC. 

Switching tack for UK swap rates 

We’ve seen a few trend shifts over the past few weeks with swap rates across territories. UK swap rates have seen some relief over the course of the month, particularly at the start of May in the wake of the Federal Reserve’s latest meeting. As we have commented on in previous Rate Wraps, the actions of the US have a ripple effect around the globe, and Fed Chair Jerome Powell’s comments were no exception. He downplayed the hawkish messaging of rate hikes being on the cards still, and this has been reinforced by the non-farm payroll figures which undershot expectations by 65k (expected 240k, actual 175k). Off the back of NFP figures, market pricing moved to price back a rate cut into the books for the US to September time, and the UK moved in tandem to shift back to an August cut. The trajectory for the UK has now swung back upwards following the inflation figures, and 2-year swap rates went up 16bps on the news.

Central bank divergence continues

As Cameron explored in our April Rate Wrap edition, the misconception that other central banks might wait for the Federal Reserve’s first step on the rate cut journey before embarking on the same path themselves is all but extinguished. In particular, Sweden’s Riksbank cut rates earlier this month by 0.25% to 3.75%, and the Swiss National Bank also cut rates earlier this year. Market pricing (as at 20 May) has all but fully priced in a rate cut for the ECB for its June meeting, with a 97% chance of a cut. ECB President Christine Lagarde spoke earlier this month, stating that the ECB was “data dependent, not Fed dependent”, and ECB Board Member Klaas Knot reiterated this dovish messaging by suggesting that to “gradually take our foot off the brake” is the direction of travel for Eurozone monetary policy. 

The main question mark that surrounds central bank actions isn’t so much whether central banks will wait for the Fed, but by how much they can loosen policy without impacting their own economy. If theory is to be considered, if the ECB cuts rates before the Fed, then we are likely to see a weaker euro and stronger dollar, creating imported inflation into Europe. However, it can be argued that interest rate differentials only form part of the picture, and the prospect of a slightly weakened domestic currency shouldn’t wholly distract from the wider economic backdrop for monetary policy. 

Overall, market pricing shows that the ECB will be the next central bank to begin its cutting cycle as early as June. The Bank of England is then expected to follow most likely in August or September time, with the Fed lagging behind around September time. Market reactions to the election announcement for 4 July have been fairly muted, and the majority of the movement is expected once campaigning and polling starts. However as ever with markets, time will tell, and even the most well-intentioned plan can be derailed by an unforeseen circumstance…

Jasmine Crabb, Capital Markets