UK CPI inflation surprised on the upside in May and on the downside in June. The “big picture” is that it is above the MPC’s forecast and will probably still reach 3.0% later in 2017, despite lower-than-expected energy prices.

Annual CPI inflation fell from 2.9% (2.87% before rounding) in May to 2.6% (2.64%) in June. Lower motor fuels inflation accounted for 11 basis points of the decline (i.e. about half) with the remainder due to “core” components.

CPI inflation averaged 2.74% in the second quarter, above the MPC’s forecasts of 2.65% and 2.43% in the May and February Inflation Reports respectively. The overshoot would have been larger but for a lower crude oil price than the MPC assumed.

Reasons for expecting inflation to reach 3.0% later in 2017 include:

1)    Despite a slower monthly gain in June, core* prices rose at a seasonally adjusted annualised rate of 3.0% in the latest three months from the previous three – see first chart. Annual core inflation of 2.4% in June would rise to 2.9% in October if this pace of increase were to be sustained.

 
2)    Annual core** producer output price inflation rose to 2.9% in June and usually peaks ahead of core CPI inflation, i.e. it also suggests a further increase in the core CPI rate – second chart.


3)    The headline / core gap is likely to remain positive and may widen, reflecting stronger food price inflation and a stabilisation of energy inflation after a recent slowdown (assuming stable crude energy costs). CPI food inflation rose further to 2.6% in June but is significantly lower than would be expected based on historical relationships with producer output price inflation for food products (5.8% in June) and the annual increase in the FAO’s global food commodity price index, expressed in sterling (19% in June, down from a peak of 36% in January) – third chart.


*Excluding energy, food, alcohol, tobacco and education, and adjusted for the estimated impact of VAT changes.
**Excluding food, beverages, tobacco and petroleum.