Inflation retreats - but it's coming back

Britain's inflation figures delivered some unexpectedly good news this week. But whilst the immediate pressure on the BoE to hike rates has eased, the long-term outlook remains grim.

Britain's inflation figures have for a change delivered some unexpectedly good news. The Consumer Price Index (CPI) posted the biggest monthly drop in seven years in July, taking the annual rate of inflation to 1.9% from June's 2.4%; it's the first time since the spring of 2006 that inflation has undershot the Bank of England's 2% target. Sterling fell below the $2 mark as the threat of another interest-rate hike appeared to recede.

Behind the numbers

But while the immediate pressure on the Bank to hike rates further has eased, "there was little" in the numbers "to suggest that the UK's inflation problem has gone away", as Lombard Street Research pointed out. While goods inflation has turned down, service sector prices are still expanding by over 3.5% a year. The dip in inflation was driven by falls in food, down 5.2% on the month a result of supermarket discounting and lower furniture and household goods prices. That's due to the usual seasonal pattern, in which retailers slash prices in July; given the scale of the price reductions (furniture fell by 10%), above-average price hikes are on the cards for August, said Lombard Street. As for food, "it is almost inconceivable that inflation won't rebound", given recent floods and droughts and strong global demand, said RBS's Ross Walker.

Meanwhile, high oil prices also point to inflationary pressure ahead, and companies' pricing power remains a concern; Capital Economics noted that the latest producer price data show manufacturers raised their selling prices even though their costs fell. A hike to 6% is still "more likely than not".

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Importing China's inflation

Over the longer term, evidence is mounting that cheap Chinese imports, which have kept a lid on inflation, are set to get pricier. Goods inflation has ticked up over the past year, while clothing and footwear had the biggest upward impact on inflation in July. In the US, Chinese import prices have turned positive.

China's inflation rate soared to a ten-year high of 5.6% in July, a far cry from the government's 3% target. China's decade-long boom and strong growth in the money supply 18.5% in July is creating inflation, said Ian Campbell on Breakingviews. It's largely due to China's trade surplus, which creates massive foreign exchange reserves $1.3trn in June that leak into the economy, stoking price rises. Higher prices and wages inside China mean dearer exports. China is now "adding to inflation in the West" and thus reinforcing pressure on central banks to raise rates.