Market Update: UK Inflation Shocker

Britons got an unwelcome surprise last week. Inflation, as measured by the consumer prices index (CPI), climbed 10.4% year-on-year in February, higher than January’s 10.1% figure and above economists’ expectations. Before this news, things were looking better for the UK economy, albeit only slightly. Falling fuel prices, easing global input costs and a small but consistent slide in monthly inflation had suggested ‘peak’ inflation was behind us, a view even endorsed by the Bank of England (BoE). Market rumours were that the central bank might slow down or even suspend its interest rate rising cycle in response. The latest data poured cold water on those suggestions. To account for stubbornly high inflation, capital markets’ implied rates expectation moved up swiftly after the data release and correctly predicted the BoE’s actual rates increase by 0.25% on Thursday.

Food, drink and clothing were the main culprits for this unexpected rise. According to the Office for National Statistics (ONS), food and non-alcoholic drink prices rose 18% in February, the fastest pace in 45 years. This was despite food prices outside of the UK generally falling over the last few months, suggesting this particular problem is specifically British. Surging food prices are especially damaging for lower income households, who spend a higher percentage of their incomes on food and drink.

Even disregarding the food element though, prices were still higher than expected. Core inflation – which strips out more volatile elements like food and fuel – came in at 6.2%, higher than January’s 5.8%. This is a measure the BoE pays close attention to, as it is thought to be an indicator of deeper, more persistent, ‘stickier’ inflationary trends. Along those same lines, inflation in the services sector rose to 6.6% from 6.0% the month before.

The BoE was concerned enough to raise the base rate to 4.25%. Since prices started soaring, policymakers’ biggest concern has been the threat of a wage-price spiral, where employees react to higher prices with higher wage demands, which in turn cause businesses to raise prices again.

Prices for services are particularly sensitive to wages, meaning its significant increase is a sign of stronger-than-expected wage pressures. But despite the fear around wages, it is significant that we have seen relatively marginal impacts on overall inflation.

However, the rise in food and clothing prices is notable. Food and non-alcoholic drinks had a mammoth 18% year-on-year rise in February. Before now, price increases for such consumer goods appeared mainly to be the result of input cost pressures, with few goods sellers increasing their overall profit margins. For intermediaries, like supermarkets, the global inflation surge even compressed their margins somewhat, as they were not passing through all input price increases.

At the same time as the CPI data is released, we get producer price data. The chart below shows a comparison of the food price components for consumers and producers, on a rolling annualised three-month change basis. Both are still rising, but end prices are still surging while intermediate costs are moderating somewhat.