Higher than expected inflation last month is likely to encourage the Bank of England to pause interest rate cuts and will require governor Andrew Bailey to write a letter to chancellor Rachel Reeves to explain why inflation has breached the central bank’s 2% target.
Whenever the headline inflation rate deviates by more than one percentage point from the BoE’s 2% target, the governor must explain to the finance minister why and what the monetary policy committee will do to bring it down again.
Bailey will already have sketched out his letter as the BoE had projected a rate of 3.4% for April, with the spike in prices last month marking the first time that annual inflation has risen above 3% since March last year.
Inflation had been forecast to start the new financial year with an upward spike due to expected factors like a rise in energy price cap and water bills.
The April surprise does not necessarily change the view that the BoE will cut rates two more times this year, said economist Kallum Pickering at Peel Hunt, though the data will “probably eliminate any chance” that the BoE will cut again as its next meeting on 19 June.
The question is whether higher inflation is a temporary blip or something more permanent, with a sharp rise in service price inflation to 5.4%, up from 4.7% and higher than the 4.8% forecast, potentially worrying as this measure that tends to be more sticky.
Pickering said: “If the recent trend of upside surprises to UK economic activity – especially in domestic-oriented sectors such as retail – continues, and the outsized April jump in prices leads to a slower disinflationary process as stronger demand amplifies even small second-round inflationary effects, it could shift the calculus at the BoE and encourage policymakers to hold through the third quarter as a precautionary measure, before re-starting the cutting cycle once inflation data are closer to the 2% target again after these one-off effects have fully washed out.”
While April had been expected to see a rise in inflation, the 3.5% rate indicated “that businesses have passed higher costs on to consumers by more than thought likely”, said Jeremy Batstone-Carr at Raymond James.
He agreed that the rise in services CPI was a “bigger concern” for the BoE, with rate-setters likely to focus on the jump in rises in airfares, which Ryanair recently flagged in its results, mobile phone bills, restaurant prices, transportation fees and utilities costs, all of which are likely to prove persistent.
“The Bank will hope that the softening labour market might prove sufficient to keep wage increases and higher inflation expectations under control, but this cannot be guaranteed,” Batstone-Carr added.
The market reaction to the inflation figures was immediate, with higher bond yields and a pop higher in sterling, said Kathleen Brooks, research director at XTB.
Higher inflation is “supportive of a stronger pound, as rate cut expectations get priced out by the market”, she said.
There are now 1.6 rate cuts expected by the MPC for the rest of this year, and expectations of a rate cut in August fell back to 50% from 58% on Tuesday.
“The risk is that the added pressure to consumers caused by rising levels of energy bills and tax increases will erode consumption and could weigh on growth after a strong start for the UK economy in Q1,” Brooks said.
