UK August CPI release to set tone before BOE rate call

The August UK inflation report, due later in the European session today, stands as the foremost economic data release. Arriving just one day before the Bank of England's rate decision on Thursday, it represents the final substantial piece of data for policymakers ahead of their votes.

Firstly, let us examine the anticipated figures.

Headline annual inflation is forecast to climb to approximately 3.1% in August, compared with 2.9% in the prior month. That would be about three-tenths of a percentage point above the BOE's own projection.

Even on that basis alone, the outlook appears somewhat uncomfortable. However, one should not become overly focused on the headline number, as the details within inflation data are crucial.

A significant portion of the increase in headline inflation is attributed to a sharp rise in petrol and diesel prices, which could contribute roughly two-tenths of the forecast shortfall. This matters because policymakers will be far more concerned about whether the latest energy price shock is spilling over into other key categories, rather than merely reacting to higher fuel costs directly.

That again places the spotlight on core annual inflation. The consensus estimate is around 2.6% in August, unchanged from the prior reading.

Core goods inflation is expected to remain broadly steady, which will focus attention firmly on services inflation.

The consensus for services inflation is approximately 3.5%, still well above the BOE's forecast of about 3.26%. That said, categories such as air fares could make the reading particularly volatile. July's increase in air fares was unusually mild, so some normalization is expected in August. Analyst estimates vary widely, but a monthly rise of around 10% would alone contribute roughly 8 basis points to services inflation. This is worth noting.

In other words, a services print of 3.5% is not necessarily as hawkish as it might initially seem. The details are what matter.

That will likely be the key distinction for the BOE's decision tomorrow. The central bank is already aware that inflation is trending higher. However, what policymakers truly need to ascertain is whether those price pressures are becoming more entrenched elsewhere in the economy.

So far, evidence of significant second-round effects remains scarce.

With this in mind, a report that meets expectations should still allow the BOE to leave the bank rate unchanged at 3.75% tomorrow.

A material upside surprise in underlying services inflation—and by extension, core annual inflation—could prompt markets to bring forward expectations for another BOE rate hike. For sterling and gilts, that will be the key area to monitor when the data is released later. However, it would take a very substantial surprise to convince markets to price in a rate hike for this week.

The current environment shows that traders have fully priced in a 25 basis point rate hike for November next, with another for December nearly fully priced in as well. The market pricing trajectory through to June next year implies approximately 103 basis points of rate hikes. How the yield curve shifts following today's report will be the more interesting aspect.