UK inflation has decreased to 1.7% in September, dropping below the Bank of England’s target and opening discussions about potential interest rate cuts. This shift in inflation was unexpected, with a more significant reduction than foreseen by analysts and the Bank of England. Despite the decline in inflation, there were notable shifts, including rising food costs. Financial markets reacted to this change, with significant impacts on currency and bond yields. The Bank of England faces mounting pressure to adjust interest rates sooner than anticipated.
The Office for National Statistics (ONS) reported that UK annual inflation fell to 1.7% in September, descending from 2.2% in August. This decline surpassed expectations, as analysts predicted a smaller decrease to 1.9%, and the Bank of England estimated a modest reduction to 2.1%. Primarily driven by lower airfares and fuel prices, this decrease was partially counteracted by an unexpected rise in food and non-alcoholic beverage prices, which increased from 1.3% to 1.8%. Even with this increase, food price inflation remains significantly lower than the peak levels seen in March.
The financial sectors promptly reacted to this inflation update. The British pound depreciated by 0.62% against the US dollar, settling below $1.30, and also weakened by 0.49% against the euro, dropping to €1.194. The bond market mirrored these shifts, with the 10-year UK government bond yield declining by 1.8% to 4.1% and the two-year bond yield falling by 2.5% to 4.03%. These market movements reflect growing expectations for imminent interest rate cuts.
This pronounced decline in inflation presents a strategic advantage for Chancellor Rachel Reeves as she plans her first budget on October 30. The lower inflation rate enhances the prospects of the Bank of England reducing interest rates more rapidly, facilitating the Chancellor’s goal of closing a £40 billion fiscal gap. The possibility of adjustments in capital gains tax and the imposition of national insurance on employers’ pension contributions are subjects of ongoing financial speculation.
The ramifications of a reduced inflation figure extend to benefit payments, traditionally adjusted according to September’s inflation rate. With potential for a smaller increase in benefits, the financial strain dubbed “fiscal drag,” which emerges when wage increases push workers into higher tax bands, might slightly relax. However, due to recent summer wage growth, the state pension is still expected to rise by £460 next year.
Economists are closely monitoring the Bank of England’s response to these developments. The anticipated Monetary Policy Committee (MPC) meeting on November 7 is under scrutiny, with widespread forecasts of further interest rate cuts. Paul Dales of Capital Economics suggested subsequent reductions could follow in December. Despite this consensus, the MPC remains divided, as some members express concerns about ongoing inflationary pressures. Services inflation notably decreased from 5.6% to 4.9% in September, while core inflation, excluding food and energy, reduced from 3.6% to 3.2%, fueling predictions of additional rate cuts.
The significant drop in UK inflation to 1.7% has set the stage for possible interest rate cuts, reflecting ongoing economic adjustments.
