Thoughts on UK CPI disinflation hard to shake off

So, the UK CPI release for May was in-line with expectations, however, the big story of the morning is not that the UK exited deflation last month, rising from -0.1% to 0.1% in May, instead it is that producer prices remained mired in negative territory and even house prices disappointed, although that may be temporary.

Digging into the CPI data, the largest upward contribution came from airfares, which the Office for National Statistics (ONS) attributed to the timing of Easter, so could be temporary. The largest downward pressures came from recreation and culture, particularly toys and computer games.

Producer prices could limit CPI upside

Although the UK’s dalliance with deflation was short-lived, we are not out of the woods yet. Producer prices, which are a good indication of pressure in the UK’s inflation pipeline, remain mired in deflationary territory. Input prices, fell 0.9% in May, the market had been looking for a rise of 0.6%, this pushed the annual rate down to -12%, erasing a recent attempt at recovery. Output prices remained down 1.6% on an annual rate, while core output prices stayed flat.

Raw materials, including energy prices, have stalled after a failed attempt at recovery in recent months. Brent crude oil is trading in a tight range between $60-$65, and the medium-term outlook remains bearish due to the glut of oil that remains on the market. Without a recovery in commodity prices, the bias could remain lower for producer prices over the coming weeks and months.

As we mention above, if producer prices stay weak then this could keep price pressures further up the inflation pipeline capped. Thus, the expected recovery in CPI may not materialise and the UK could remain mired in disinflation for some time to come. Ultimately, this need not be a bad thing for the economy since disinflation can spur consumption, but it could delay any rate hike from the Bank of England, which may limit GBP upside.

Election fears weigh on house prices:

The Office for National Statistics also released house price data for April, which saw house price growth slow sharply to 5.5% from 9.6% in March. This sharp decline looks like a temporary blip due to election fears, and we expect house price growth to pick up in the coming months.

Inflation and GBP

Immediately before the release the pound started to tumble, dropping from 1.56 – 1.5580, which was coincidental timing, I’m sure!

The decline has continued, and GBPUSD is currently making lows of the day below 1.5550. Considering this pair was testing 1.5630 earlier this morning, it’s been a fairly hefty decline. Strong support remains at 1.5486 – the 200-day sma.

The pound’s decline is hardly surprising, since G10 FX is driven by relative interest rate differentials right now. UK yields have fallen 4 basis points on the back of the inflation data, which is not much, but is enough to take the shine off sterling this morning. In the longer term, GBP’s outlook will be determined by the outcome of the FOMC meeting this week, if the Fed sounds hawkish then GBPSUSD could test the air below key support at 1.5486 – the 200-day sma.