UK Inflation Overshoots Again, Raising Pressure for Higher Rates

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(Bloomberg) — U.K. inflation remained higher-than-expected for a fourth month, prompting a fresh wave of bets on higher interest rates as consumers struggle with higher mortgage costs.

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The consumer price index rose 8.7% in May, the same as the previous month, the Office for National Statistics reported on Wednesday. Core inflation, excluding food and energy, unexpectedly accelerated to 7.1% from 6.8%. Economists had expected the headline reading to remain at 8.4% and the core unchanged.

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The figures raise the specter of the Bank of England choosing to raise interest rates further on Thursday in the fastest monetary tightening in four decades. A separate report showed that government debt now exceeds the size of the British economy for the first time since 1961, threatening Prime Minister Rishi Sunak’s promise to restore health to public finances and lower inflation.

“It looks increasingly likely that it will take a recession to finally put the inflation genie back in the bottle,” said Stuart Cole, chief macro economist at Equiti Capital in London.

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Traders piled their bets for further rate hikes from the Bank of England. Money market pricing fully priced its core rate to 6% by December. Investors see a 50% chance that officials will opt for a larger half-point hike on Thursday.

What does Bloomberg Economics say…

May’s surprise spike in core inflation will overshadow the BoE’s June meeting. While we still think a 50 basis point hike is unlikely, there’s now a good chance the minority will vote for a bigger move. Tighter central bank messaging is also likely, although we think any adjustments are likely to be fairly measured – rate expectations have risen since the last BoE meeting, but it’s not clear they need another push higher.

—Dan Hanson and Ana Andrade, Bloomberg Economics. Click for reaction.

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The Bank of England has raised rates at 12 consecutive meetings from 0.1% to 4.5% and economists expect to raise them by at least a quarter point to 4.75% on Thursday.

“It is possible that the Bank will raise interest rates by 50 basis points tomorrow and will need to push rates above 5.25% to outpace core inflation,” said Paul Dales, chief UK economist at Capital Economics. “The acceleration in core inflation is making the UK look increasingly like the outlier and stagflationary nation.”

Used car prices along with airfare and the cost of entertainment and culture drove the increase, suggesting that price pressures have spread beyond food and energy to the rest of the economy.

“The cost of air tickets has risen more than a year ago and is at a higher than normal level for the month of May,” said Grant Fitzner, chief economist at the Office for National Statistics. Live music events and computer games also contributed to persistently high inflation. This was offset by a decrease in the cost of gasoline. Food price inflation remains high, but the rate has decreased slightly.

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Britain remains far behind the major economies with prices rising four times faster than the central bank’s 2% target. Bank of England Governor Andrew Bailey is worried about signs of persistent inflation despite the fastest round of interest rate hikes in four decades.

“Higher headline inflation is piling on the pressure for more rate hikes,” says Yael Selvin, chief economist at KPMG UK. “Today’s data will probably leave the Bank of England with no choice but to opt for another hike in the benchmark rate tomorrow.”

Two measures of price are being watched closely by the BoE for signs of domestically generated inflation picking up again. Core inflation – which excludes volatile food and energy prices – unexpectedly accelerated to a 30-year high of 7.1% while services prices rose 7.4%, up sharply from a 6.9% rise in April.

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The deficit is rising

In a separate report, the Office for National Statistics said government debt rose above 100% of gross domestic product for the first time since 1961 after the government borrowed 20 billion pounds ($25.6 billion) more than expected in May.

The deficit, the second highest in the month since modern records began in 1993, rose from 9.4 billion a year earlier. The increase was driven by payments for the cost of living, including energy subsidies, and higher staff costs.

The numbers make it difficult for Sunak to implement the deep tax cuts that many conservatives say are necessary if the party avoids defeat in a general election expected next year.

High inflation and high interest rates are also weighing on public finances. Debt servicing costs for the month of May alone were £7.7bn, £700m more than the Office for Budget Responsibility forecast.

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Public sector strikes as workers demanded to keep up prices led to bigger pay deals than the government had planned.

As a result, staff costs were up by £3.4 billion from last year – largely due to the NHS wage deal. The cost of subsidizing household energy bills was £3.6 billion in May, an increase of £1.4 billion on last year. Inflation also added £2.9 billion to social care spending, as benefits were raised in line with inflation in April.

Chancellor of the Exchequer Jeremy Hunt said the priority was fighting inflation.

“We will not waver in our intention to support the Bank of England as it seeks to drive inflation out of our economy, while providing targeted cost-of-living support,” Hunt said in a statement. “We know how damaging high inflation is to households and businesses across the country, and our plan to halve the rate this year is the best way we can keep costs and interest rates low.”

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The rate of inflation is falling more slowly in the UK, in part because falling commodity prices are being passed on to regulated domestic energy bills with a lag. Also, Britain has had more than 500,000 people drop out of the labor market during the pandemic, forcing companies to raise wages to secure the staff they need.

Bailey said last week that inflation will come down but it will take “much longer than expected”. He warned of an “extremely tight” job market, noting that many companies are stockpiling workers due to recruitment difficulties.

Slowing inflation is crucial to the political fortunes of Sunak, who has made halving price growth by the end of the year one of his five major pledges.

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— With assistance from Andrew Atkinson, Elena Ganatra, and Greg Ritchie.

(Government debt updates and comment from the third paragraph).

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