A recent monthly survey jointly published by Citi and YouGov reveals a significant drop in UK households' inflation expectations for June, as oil prices retreated. The one-year-ahead inflation expectation fell to 3.8% this month from 4.7% in May, returning to the level seen in January before the outbreak of the Iran conflict. Long-term inflation expectations also decreased by 0.1 percentage points to 3.9%, aligning with the six-month average prior to the conflict. This data provides the Bank of England with fresh evidence that the risk of inflation expectations becoming "unanchored" is receding, leading to a further reduction in market bets for a rate hike from the central bank this year.
Primary Driver of the Sharp Decline: Falling Oil Prices
The sudden retreat in inflation expectations is most directly driven by declining energy prices. International oil prices have fallen notably since a ceasefire agreement between the US and Iran allowed shipping to resume through the critical Strait of Hormuz. Buoyed by the ceasefire news, oil prices have dipped below $80 per barrel for the first time in three months, a significant drop from the previous high of around $108 per barrel. As the UK is heavily reliant on energy imports, the drop in oil prices directly alleviates imported inflation pressures. Bank of England Governor Andrew Bailey explicitly stated in a June 18 policy announcement that the recent fall in oil prices is "encouraging." According to the UK's Office for National Statistics, the current headline inflation rate has fallen to 2.8%, though it remains above the central bank's 2% target. Institutions now forecast that the peak inflation rate will be below 3%, significantly lower than the best-case scenario in the Bank of England's April projections.
Citi's View: De-anchoring Risk is Fading
Citi economist Callum McLaren-Stewart offered a clear interpretation of the survey results. He noted that a key aspect of the hawkish argument within the Bank of England revolves around the risk of inflation expectations becoming "unanchored." "This month's Citi/YouGov survey results should weigh against that," McLaren-Stewart stated. "We think the risk of de-anchoring is fading." This assessment aligns with the cautious stance held by the majority within the central bank. While two committee members advocated for an immediate rate hike, the majority believes that weakening demand and a loosening labor market may help mitigate some secondary inflation transmission pressures. Data shows that since the Iran conflict began in February, the UK has lost approximately 64,000 jobs, with regular private-sector pay growth falling to a five-year low.
Reduced Pressure for Bank of England Rate Hikes
Internal Divergence Persists, Hinging on Inflation Outlook
The cooling of inflation expectations provided crucial support for the Bank of England's June 18 interest rate decision. On that day, the Monetary Policy Committee (MPC) voted 7-2 to hold the Bank Rate steady at 3.75%, marking the fourth consecutive meeting of unchanged policy. The dissenting votes came from external members Megan Greene and Chief Economist Huw Pill, who argued for an immediate 25 basis point hike to 4% to curb any further rise in inflation expectations. Pro-hike members believe preemptive tightening is necessary to manage household expectations for future inflation. Governor Bailey maintained his stance of "actively holding steady," noting that compared to the market's expected path of rate cuts before the conflict, the current hold itself constitutes a form of effective tightening. Most members believe that tighter financial conditions since the Middle East conflict have provided a buffer against inflation.
Regarding inflation forecasts, the Bank of England made two-way adjustments. It now expects CPI to rise above 3.25% in the fourth quarter of this year, higher than the 2.8% forecast in May but below the 3.6%-3.7% range in April's scenario analysis. Concurrently, the forecast for underlying GDP growth in the second quarter was revised up to 0.2%, an improvement from the 0.1% predicted in April. The MPC meeting minutes indicated unanimous agreement among members that "an appropriate policy response would be forceful" should inflation rise further. The Committee reiterated its readiness to "take whatever action is necessary to ensure that CPI inflation returns to the 2% target in the medium term."
Market Expectations Reverse: From Cuts to Hikes to Wait-and-See
Market expectations for the Bank of England's policy path have undergone a dramatic reversal over recent months. Before the US-Iran conflict erupted in February, markets widely anticipated the start of a rate-cutting cycle this year. As the conflict drove energy prices higher, expectations swiftly shifted towards bets on rate hikes. Now, with inflation expectations falling, market expectations have adjusted again. As of June 18, markets were pricing in just 22 basis points of tightening by year-end, whereas during peak US-Iran tensions, markets had predicted three to four 25-basis-point hikes.
Capital markets broadly anticipate that the timing of a potential Bank of England rate hike this year is most likely delayed until December. Morgan Stanley has pushed back its forecast for a hike from July to November, warning that if economic slowdown pressures are weaker than expected, delayed tightening could lead to a secondary inflation rebound, potentially leaving the central bank's policy reactive.
Outlook: Sustainability of Ceasefire Remains a Key Variable
Although the fall in inflation expectations has bought the Bank of England some policy space, the outlook remains subject to significant uncertainty. The Bank lowered its forecast for the Q4 inflation peak to above 3.25% in its June meeting, though this is still higher than May's 2.8%. Governor Bailey emphasized in the statement that higher energy prices over the past four months have already meant some inflationary pressures are in the pipeline. The MPC minutes reiterated the members' unanimous view that a forceful response would be appropriate if inflation rises further, and the Committee stands ready to act to ensure inflation returns to the 2% target.
The sustainability of the US-Iran ceasefire remains the market's greatest uncertainty. While the ceasefire news has boosted market confidence, the Bank of England warned of risks of logistical delays in restoring energy supplies and ongoing instability. Should geopolitical tensions escalate again, energy prices could rebound swiftly, potentially driving inflation expectations higher once more.
Simultaneously, the UK's real economy is showing signs of fatigue. Latest data shows GDP unexpectedly contracted by 0.1% month-on-month in April. The April contraction was primarily driven by energy price increases and rising inflation expectations triggered by the Middle East conflict, with a 0.2% contraction in services being the main drag.
June PMI data further corroborates the weakening economic momentum. Data released by S&P Global shows the UK's preliminary June Composite PMI fell to 49.4 from 49.7, remaining below the 50 threshold that separates expansion from contraction for a second consecutive month and hitting a 14-month low, significantly worse than the market expectation of 50.6. The preliminary Services PMI dropped to 48.7 from 49.3 in May, marking a 41-month low and falling short of all economists' forecasts. The preliminary Manufacturing PMI declined to 53.1 from 53.9, also missing expectations.
RBC Capital Markets analyst Cathal Kennedy noted that the preliminary June PMI data suggests economic growth could slow sharply in the coming quarters. After experiencing the fastest growth among G7 nations in Q1, the UK economy now faces prospects of stagnation or even contraction in Q2. The Bank of England is currently caught in a dilemma: inflation remains stubbornly high, while the growth engine is clearly losing steam. The Committee believes that weakening demand and a loosening labor market may alleviate some secondary inflation pressures, but this also highlights the complexity of balancing the fight against inflation with the need to support growth.
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