A sharp drop in UK inflation compounded a summer of market volatility leaving analysts unsure what the Bank of England’s next move on interest rates would be.
UK Daily View
Video: Chris Giles looks at the impact on interest rates
July’s annual consumer price inflation rate plummeted to 1.9 per cent from 2.4 per cent in June, surprising investors who had expected a modest drop to 2.3 per cent. It was the largest monthly fall for five years in annual CPI inflation and the first time the measure was below the bank’s 2 per cent target since March 2006.
Sterling dipped on Tuesday below $2 for the first time since mid-June and at the end of the day’s trading, market interest rate expectations for next spring had fallen by 0.08 percentage points – suggesting that the City of London is much less sure than it was last week that the Bank of England will raise interest rates one more time to 6 per cent.
Michael Saunders, UK economist of Citigroup, said: “You can’t dismiss a surprise on inflation as big as that. A week ago I thought there was an 80 or 90 per cent chance of a rate rise, now that could be less than 50-50.”
The inflation drop was caused by sharp monthly declines in food prices, alongside the largest ever monthly fall in furniture prices. Combined, these two elements took 0.35 percentage points off the annual inflation rate and forced both the headline and core measures lower.
Economists argued that some of the falls were likely to be temporary. Ross Walker of the Royal Bank of Scotland said: “It is almost inconceivable that food price inflation will not rebound in the months ahead given the combination of supply shocks [floods and droughts, depending on location] and buoyant global demand.”
But the scale of the dip was such that Mr Walker added, “this will help reduce the risks of a subsequent overshoot in inflation”.
The Bank of England is likely to view the figures with caution as its interest rate strategy aims to control the level of demand over the next two years with its assessment of the level of goods and services the economy can produce.
Nothing in that analysis is changed by inflation figures for July.
The Bank has, however, been swayed into raising rates by high headline inflation figures this year, which suggested demand pressures were more acute than thought.
A consensus emerging among financial market economists yesterday was that the figures would give the bank pause for thought as they might suggest demand pressures were lower than feared and that they would help reduce inflation expectations.
The Bank was expected to now wait and see how inflation and the economy developed before changing its policy rate again from its 5.75 per cent level.
