Is a nasty inflation surprise on the menu?

I became acutely aware of ‘menu costs’ early on in my career when my regular pizza restaurant jacked up the prices one April with a shiny new menu as they begun their new financial year.

I’ve previously written that while the Bank of England (BoE) could be getting closer to cutting rates, we were unlikely to see a move before the key April inflation numbers were available. There’s good reason for that, with a number of menu cost items, most notably public rent, utility bills and various labour-intensive services – such as my old pizza haunt – set to ‘reset’ upwards in April. This in turn could keep inflation sticky and give the BoE reason to be cautious.

Last year, we warned consensus was too complacent on April inflation data. There was a huge 0.8% upward surprise to core inflation (CPI) on the day the data figures were announced, and gilt yields shot up amid a change in market narrative. However, the concerns proved relatively short-lived, with yields falling after the summer as inflation resumed its downward trend. Now, gilt yields are rising again on the back of sticky US inflation data. Is the market set for another jolt on bad UK data too?

Devil in the data detail?

We’ve again looked at the micro details and worry about several components of the inflation basket. This includes water bills (up 6% this April), public sector rents (up 7.7% this year) and telecommunication services (up 8% this April). These are examples of where prices are indexed to past inflation.

However, there are also indirect indexation effects (see my blog on the price-wage echo) from the rise in the national living wage of 9.8%. On a more positive note as far as the inflation reading is concerned, there are still some favourable base effects from core goods which rose 0.8% last April on a 'seasonally adjusted’ basis versus 0% in recent months.

Headline inflation still set to fall below 2%?

Moreover, we still see the collapse in energy prices pushing headline UK inflation to 2% in April and to a psychologically important 1.8% in May / June. But we now see inflation being at or even above target throughout the second half of the year (some UK forecasters are talking in terms of inflation falling towards 1%). The further out we go, the more inflation uncertainty rises.

Big picture, UK inflation is falling, but it might not fall as much as hoped – those expecting large and sustained below-target prints could be disappointed. With UK credit conditions also easing again, the BoE is likely to be cautious about how quickly it cuts interest rates this year. We now expect cuts in August and November.