After a brief summer reprieve, UK households are once again confronting the reality of rising energy bills. Data released Wednesday by the Office for National Statistics (ONS) showed the consumer price index (CPI) rose 2.9% year-on-year in July, up from 2.6% in June and marking the highest level since March this year. The reading broadly matched the median economist forecast, slightly exceeding the Bank of England's projection of 2.8%, yet the formal reversal of the disinflationary trend still casts a shadow over the UK's economic outlook.
The headline rebound was in line with expectations: energy bills served as the inflation engine, while cooling services inflation provided some comfort. The core tension in July's inflation data lies in the coexistence of an energy-driven headline rebound and continued easing in domestic price pressures. The ONS noted that the main driver of July's inflation rise was the housing and household services category, directly reflecting the quarterly price cap adjustment by energy regulator Ofgem that took effect on July 1, which raised the cap on household gas and electricity bills by 13%, adding approximately £221 to the average annual household bill, bringing it to £1,862. Specifically, gas prices jumped 14.7% month-on-month in July, the largest monthly increase since October 2022, while electricity prices also rose 3.6%.
However, inflationary pressures did not spread to the broader economy. Core CPI, excluding energy, food, alcohol, and tobacco, held steady at 2.6% year-on-year, marking the third consecutive month of stability. This reading was slightly above the 2.5% economists had expected but did not alter the underlying picture of core inflation stabilizing. More encouraging for the Bank of England was the unexpected cooling in services inflation, a key gauge of domestic economic pressure, which fell to 3.4% from 3.6% in June. This was largely due to airfare price increases (+11.7%) in July being far below those of the same month last year (+30.2%). The CPIH measure, including housing costs and the ONS's preferred inflation gauge, rose to 3.1% from 2.8%.
Why hasn't the energy shock evolved into broad-based inflation? There is a fundamental difference between this inflation rebound and the 2022 energy crisis: the transmission mechanism is now vastly different. In 2022, surging energy prices quickly fed through to food, transport, and core goods prices, triggering widespread inflation. This time, the pass-through effect is clearly limited. Falling gasoline and diesel prices have played a key offsetting role—diesel prices fell by 8.8 pence per liter month-on-month in July, airfares dropped 11.6% year-on-year, and lower crude and refined product prices drove a 1.7% month-on-month decline in input prices, effectively curbing the spread of the energy shock to broader areas. Additionally, continued cooling in food inflation has provided consumers with some relief. In July, food and non-alcoholic beverage prices rose just 1.3% year-on-year, down from 1.7% the previous month and the lowest level since September 2021, with this category contributing only 0.14 percentage points to annual CPI growth, also the lowest since 2021.
KPMG Chief Economist Yael Selfin pointed out that unlike 2022, when energy price rises led to widespread cost increases across the economy, the current soft labor market conditions help limit the scale of such cost pass-through. This assessment aligns closely with labor market data released Tuesday, which showed continued cooling in employment and slowing private-sector wage growth.
Market reaction: sterling edged up slightly, while rate hike bets cooled. Following the data release, the British pound rose about 0.1% against the U.S. dollar to near 1.3550, though it remained confined within the weekly range below 1.3570. Traders slightly reduced their bets on a Bank of England rate hike before year-end. The latest survey shows a vast majority of economists expect the Bank of England to hold its benchmark rate at 3.75% for the remainder of 2026. This subdued market response precisely underscores that investors had fully anticipated the inflation rebound. Economists generally view July's inflation rise as the result of base effects and one-off policy adjustments, rather than a substantial deterioration in domestic price pressures.
Softness in the services sector is emerging as a key buffer against second-round inflation effects. Data released Tuesday showed the UK labor market continuing to cool, with non-farm employment falling and private-sector wage growth slowing. This weakness limits businesses' ability to pass on higher energy costs to consumers and provides justification for the Bank of England to maintain current interest rate levels.
The Bank of England's dilemma: inflation rebound versus economic weakness—how long can it hold steady? July's inflation data sends a nuanced policy signal to the Bank of England. The hawkish argument: CPI jumped from 2.6% to 2.9%, and the Bank projects inflation will peak at 3.2% in the fourth quarter. Energy bills could rise again, and risks of drought and extreme weather could push food inflation higher in 2027, suggesting inflation may not yet have peaked. The dovish argument: core inflation held steady at 2.6% for a third consecutive month, services inflation unexpectedly cooled to 3.4%, and the labor market continues to weaken with slowing private-sector wage growth. As KPMG's Yael Selfin noted, labor market weakness helps limit the scale of cost pass-through. According to a survey released on August 18, around 90% of economists expect the Bank of England to keep rates unchanged in September or for the remainder of 2026, with the benchmark rate staying at 3.75%. Despite inflation expected to remain above 2% until the second half of 2027, a slim majority of economists still anticipate at least one rate cut by mid-2027. Meanwhile, markets expect the Bank of England to hike at least once this year, with the probability of a December hike as high as 86%.
Chancellor John Healey responded to the data, stating: "Iran war inflation continues to affect domestic prices, but the UK economy remains resilient."
Inflation outlook: clouds have yet to clear. July's inflation data reveals the reality facing the UK economy: the energy bill "floodgate" has only just opened. Due to the delayed implementation of the price cap policy, UK households had previously been largely shielded from the worst effects of the Iran war. July's nearly 15% surge in gas prices marks the formal removal of this protective shield. However, the inflation rebound has not altered the Bank of England's policy path. The unexpected cooling in services inflation, continued labor market weakness, and stable core inflation provide policymakers with reason to "wait and see." The real test may come in October, when energy bills are set to rise again, albeit modestly, and the trajectory of the Middle East conflict will determine whether oil prices continue to deliver fresh shocks to UK consumers.
David Rees, Global Head of Economics at Schroders, warned that manufactured goods prices could rise in the coming months, while risks of drought and a super El Ni帽o could significantly push up food inflation in 2027. Furthermore, sustained disruptions in the Strait of Hormuz are keeping oil prices elevated, with Brent crude pushed back above $90 per barrel, which may remain a concern for the minority of Bank of England policymakers advocating for rate hikes.
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