UK's Cooling Inflation in May Supports Central Bank's Decision to Hold Steady for Now, While Middle East Conflict Brings New Uncertainties

On the day before the Bank of England (BoE) announced its interest rate decision, the UK's inflation rate cooled slightly in May. The central bank is expected to keep interest rates unchanged this week while assessing the impact of the escalating Middle East conflict on the international energy market.

Data released by the UK's National Bureau of Statistics (NBS) on Wednesday (June 18) showed that the UK's CPI annual rate stood at 3.4% in May, in line with market expectations, down from the previous reading of 3.5%. The CPI rose 0.2% MoM in May, also meeting expectations.

Food prices rose 4.4% YoY in May, the largest increase in over a year, dealing a heavy blow to low-income households.

Richard Heys, acting chief economist at the UK's NBS, said that while airfare and fuel prices fell, they were offset by rising food prices, with prices for chocolate, meat, as well as furniture and household items like refrigerators and vacuum cleaners, all climbing. "Various price movements offset each other, meaning inflation changed relatively small in May," he said.

Meanwhile, the ongoing escalation of the conflict between Israel and Iran may complicate the BoE's future decision-making, with oil prices having risen about 14% from a week ago.

Although investors and economists believe the likelihood of an interest rate cut by the BoE on Thursday is extremely low, there may still be room for further action at the August meeting.

Yael Selfin, an economist at KPMG, commented that with the escalation of the situation in the Middle East, energy prices have become a key risk to the inflation outlook, and the BoE needs to respond cautiously and will not change its policy lightly for the time being.

Sanjay Raja, an economist at Deutsche Bank, said, "The focus will now shift to geopolitical events and rising energy prices, which will undoubtedly complicate the BoE's task, as higher energy prices imply higher inflation expectations." However, Raja added that the UK's weak labor market may cool inflationary pressures.

As one of the key indicators watched by BoE policymakers, services inflation fell to 4.7% from 5.4% in April. Core inflation, which excludes volatile energy and food costs, slipped to 3.5% from 3.8%.

UK Chancellor of the Exchequer Rachel Reeves said that the Treasury has taken necessary measures to stabilize public finances and control inflation, but acknowledged that more work needs to be done.

Rob Wood, chief UK economist at Pantheon Macroeconomics, forecasts that the UK's inflation rate will fluctuate around current levels for the remainder of the year, averaging 3.4%. However, in the context of the conflict between Israel and Iran, rising oil prices may push these figures higher.

"We have not fully considered the factor of rising oil prices after the Middle East conflict. If oil and natural gas prices remain at current levels, the peak inflation rate is expected to be 3.7%. If oil prices reach $80 per barrel and natural gas prices rise accordingly, we will raise the peak inflation rate to 3.8%."