UK inflation slowed in July indicating support for Bank of England target

Inflation in the UK slowed in July, indicating that the Bank of England may find support for a rate hike in the future.

The UK consumer price index (CPI) decelerated to an annual rate of 2.8 per cent in July, slightly down from 2.9 per cent the month before and in line with expectations.

The Bank of England has promised to keep interest rates low until unemployment falls below seven per cent, but the Monetary Policy Committee (MPC) could remove the link and increase rates early if any of three "knockout" scenarios occur. One of these scenarios is if the MPC thinks inflation will be 0.5 percentage points or more above its two per cent target in 18 to 24 months' time. Another is if the MPC thinks medium-term inflation expectations no longer remain sufficiently well anchored.

So if the MPC thinks July's fall marks the beginning of a sustained downturn, this could mean the likely exclusion of at least one of these caveats.

In its August quarterly inflation report, the Bank of England predicted inflation would average 2.82 per cent in the third quarter.

July's fall in inflation was driven primarily by falling air fares and price movements in recreation and clothing and footwear sectors, offset slightly by a rise in petrol and diesel prices.

Excluding seasonally volatile products like food and energy, core CPI slowed to an annual rate of 2.0 per cent from 2.3 per cent the month before (2.2 per cent expected).

Howard Archer, chief UK and European economist at IHS Global Insight, says the dip in inflation is "moderately encouraging", although CPI could still touch 3.0 per cent in the near-term.

While growth has improved markedly recently, we believe that underlying inflationary pressures should still be held down by significant excess capacity and ongoing muted wage growth given appreciable labour market slack.

Our best bet is that consumer price inflation will dip to 2.7% by the end of 2013 and then trend down further to end 2014 just above 2.0%.

We expect the Bank of England to keep interest rates at 0.50% through to early-2016, but we believe they could start rising gradually early in 2016.

Scotiabank economist Alan Clarke says the inflation rate should be viewed in some context.

We're seeing core inflation slowing down and the Bank of England should be happy with that. But we are still a chunky margin above the 2 percent target and I don't think that is going to go away completely for some time to come.

When you compare the recent history, when you've seen inflation at 4 or 5 percent, it's a relief.... But I think it's very hard for inflation to slow to 2 percent when you've got things like university tuition fees, tax hikes and the changing clothing methodology a few years back, all making it much harder to hit 2 percent than it used to be.

The Office for National Statistics also released its figures for producer price inflation. The output producer price index (PPI) (price of goods produced) increased to 2.1 per cent from 2.0 per cent. This was driven primarily by a 5.0 per cent increase in the price of producing food products. Excluding these seasonally volatile products, PPI rose just 1.1 per cent.

Input PPI (inflation experienced by manufacturers) increased to 5.0 per cent from 2.0 per cent (1.1 per cent month-on-month).

Martin Beck, UK economist at Capital Economics, said July's fall is likely to be the start of a "sustained drop". While "base effects" like a rebound in clothing inflation and a jump in air fares in July 2012 did have some effect, Beck thinks there will be further falls ahead.

For example, producer prices figures also released today confirmed that price pressures at the very start of the inflation pipeline remain subdued. Looking forward, although there are growing signs of economic recovery, we think the degree of slack in the economy will help push down CPI inflation close to the MPC’s 2% target by the end of the year. The rationale for the forward guidance announced by the MPC last week just got a bit stronger.

Meanwhile, the retail price index (RPI) for July slowed as expected to 3.1 per cent year-on-year (from 3.3 per cent the month before).