A big upside surprise to UK inflation

Chris Scicluna
Emily Nicol

A big upside surprise to UK inflation:
Inflation in the UK in July was much stronger than expected, with the headline CPI rate rising 0.4ppt to a four-month high of 1.0%Y/Y. In contrast, the BBG median expectation, as well as our own, had been for an unchanged rate from June, while BoE staff had expected an increase of just 0.1ppt to 0.7%Y/Y.

The rise in inflation in July partly reflected the rebound in global oil prices, with petrol prices at the pump up the most in almost a decade. So, energy inflation rose more than 3ppts, albeit remaining firmly in negative territory at -9.2%Y/Y. But despite a steep fall in the airfare category (down 2.5ppts to -1.9%Y/Y) as tourists largely stayed at home, services inflation jumped too, rising 0.3ppt to 2.1%Y/Y, as many firms – including hairdressers, physiotherapists and dentists – put prices up to cover the costs of personal protection equipment (PPE) and making their premises Covid-19 secure. And inflation of non-energy industrial goods rose 0.5ppt to a near two-year high of 1.4%Y/Y, as retailers of clothing and certain other items (e.g. furniture) delayed their usual summer sales following the earlier disruption caused by lockdown (an effect seen in some euro area member states too). So, contrary to the expected decline, core inflation rose 0.4ppt to a 12-month high of 1.8%Y/Y.

Given the role of one-off (price rises to cover the costs of PPE) and temporary (delayed summer sales) effects, we expect July’s rise to be reversed in August. Indeed, inflation looks set to drop sharply, as the temporary 15ppt cut in VAT on hospitality and entertainments combines with the impact of discounted restaurant meals related to the Government’s Eat Out to Help Out scheme. And with the Government having reintroduced quarantine measures for travelers to the UK’s most popular tourist destinations (Spain and France), air fares look set to remain under downwards pressure too. So, a drop in inflation back below 0.5%Y/Y still looks on the cards, from August through to the end of the year, before the hospitality VAT cut comes to an end and firms have to contend with the additional costs related to the end of the Brexit transition. With labour market conditions rapidly deteriorating, weak wage growth should help to ensure that underlying inflation remains relatively contained next year too.

Japanese exports see moderate rebound while machine orders slump:
After yesterday’s Reuters Tankan survey suggested that Japanese manufacturers have become somewhat less downbeat this month, with the respective survey index rising to the highest in four months, today’s goods trade report signalled some improvement in demand for Japanese exports at the start of the third quarter. In particular, the value of exports rose for the second successive month in July and by 4.7%M/M. And with the value of imports down 2.7%M/M, the adjusted trade deficit narrowed to just ¥34.8bn, the smallest in more than a year.

But today’s figures mean that exports have recovered just one quarter of the decline seen between February and April, and left them still down more than 19% compared with a year earlier. The annual drop in exports came in spite of a further notable increase in shipments to China (up 8.2%Y/Y). Indeed, exports to Japan’s other regional counterparts continued to fall sharply. And while it marked a softer pace of decline than in recent months, the annual drop in the value of exports to the EU and US was still striking (-30.5%Y/Y and -19.5%Y/Y respectively), as demand for autos and machinery remained well down on a year earlier.

When adjusting for both seasonal and price effects, the export performance was somewhat more encouraging in July, rising 7.4%M/M. Admittedly, this suggested that just one third of the initial Covid-related slump in exports has been recovered. But with the volume of imports down for the third consecutive month, today’s report suggested that net goods exports provided a notable boost to GDP growth at the start of Q3, having accounted for almost 40% of the record-7.6%Q/Q contraction in Q2. But the outlook for external demand appears weak, with demand for capital goods and autos in particular likely to remain subdued. Indeed, today’s machine orders data revealed that orders for such items from overseas fell for the third successive month and by 3.9%M/M to be down a whopping 32%Q/Q in Q2.

Looking at domestic demand, while business investment encouragingly held up relatively well in the second quarter (with the 1½%Q/Q decline in non-residential investment merely reversing the increase seen in Q1), today’s domestic machine orders data – which provide a guide to capex growth three months ahead – pointed to a sharp drop ahead. In particular, core domestic private sector orders fell a steeper-than-expected 7.6%M/M in June to their lowest level since early 2013, to leave them down 22.5%Y/Y, the steepest annual decline since September 2009. This reflected a near-10½%M/M drop in orders placed by non-manufacturers, with particular weakness in the transportation and finance sectors. In contrast, orders placed by manufacturers rose in June, with the autos sector posting the first rise since January.

Of course, monthly orders figures are notoriously volatile, with particularly large swings seen in the profile over recent months. But, over the second quarter as a whole, core orders were down 12.9%Q/Q, the steepest quarterly drop since the height of the global financial crisis, with significant declines in orders placed by manufacturers (-16.6%Q/Q) and non-manufacturers (-9.7%Q/Q) alike. And despite the record stimulus package, government orders remained relatively subdued, up just 2½%Q/Q in Q2. Moreover, the Cabinet Office expected government orders to slip back in Q3, with private sector and overseas orders also forecast to decline again this quarter.

Today in the euro area and US: 
This morning brings the final euro area CPI figures for July. The preliminary estimates saw headline inflation unexpectedly rise 0.1ppt to 0.4%Y/Y, with core inflation up a steeper 0.4ppt to 1.2%Y/Y. But this increase primarily reflected a surge in clothing inflation in certain member states including France and Italy, as retailers delayed the start of the summer sales, an effect which seems bound to be reversed in August. But contrasting with the UK, services inflation fell to its weakest since April 2016 despite the extra costs of protection from Covid-19, pointing to weak underlying price pressures.

Later today brings the release of the minutes of the Fed’s end-July policy meeting. Clues might be forthcoming as to the nature of any future strengthened forward guidance, and/or the tolerance of the Committee to higher yields on USTs. In addition, further hints of an imminent shift to an average-inflation targeting approach that would see the Fed explicitly tolerate a future period of above-target inflation might also be contained within. 

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