UK inflation cools down more than expected, with the latest inflation rate falling to a three-and-a-half-year low, clearing a major obstacle for the Bank of England's path to a rate cut in November.
On October 16th local time, data released by the UK's Office for National Statistics showed that the September CPI increased by 1.7% year-on-year, a significant decline from the previous value of 2.2%, lower than the 1.9% expected by economists and the 2.1% previously anticipated by the Bank of England.
Market expectations for a rate cut by the Bank of England by the end of the year have subsequently increased. According to futures market data, investors estimate a 90% probability that the Bank of England will cut rates by 25 basis points in both November and December, while on Tuesday before the inflation data was announced, this probability was at 80%.
Both the foreign exchange and bond markets experienced significant fluctuations. After the inflation data was announced, the British pound plummeted against the US dollar, breaking through the 1.3 threshold and reaching its lowest level since August 19th. It slightly rebounded by the close on October 17th, and the British pound also noticeably weakened against the euro. The yield on the UK's two-year government bonds, which are sensitive to interest rate changes, also suffered a significant drop, falling by 2.64% on the day the data was announced, reaching a new low in nearly two weeks.
The historical return of the September inflation rate within the central bank's target range, does it indicate that the UK has achieved a phased victory in fighting inflation? Can the Bank of England smoothly enter a continuous rate-cutting channel?
Inflation cools down more than expected, but concerns about inflation persistence still exist.
The UK's Office for National Statistics stated that the inflation rate in September fell to 1.7% from 2.2% in August, the lowest level since April 2021, mainly influenced by the decline in air ticket and gasoline prices.
In August, the UK's core inflation (excluding volatile items such as energy and food prices) and service inflation pressures both rebounded. However, the core CPI for September was 3.2%, lower than the previous value of 3.6% and also lower than the expected 3.4%. The service industry inflation rate for September was 4.9%, lower than the expected 5.2%, marking the largest decline since 2020. The simultaneous decline in core inflation and service industry inflation is a positive signal that sticky inflation has been alleviated.Which factors have driven a significant decline in UK inflation?
In September, the price of goods in the UK fell by 1.4% year-on-year, remaining the main factor in the decline of inflation. The price of services rose by 4.9% year-on-year, a decrease of 0.7 percentage points from August, which to some extent alleviated concerns about the stubbornness of service inflation. Looking at specific areas, due to a significant decrease in air ticket prices and automotive fuel prices, the price of transportation in the UK fell by 2.2% year-on-year in September; however, the price of food and non-alcoholic beverages rose by 1.9% year-on-year, an increase of 0.6 percentage points from August.
The high base in 2023 can still partially explain the continued decline in UK inflation, coupled with a softening of the UK labor market leading to a slowdown in wage growth, reducing concerns about a wage-price spiral.
There are also signs that future inflationary pressures are weakening. As of September, UK factory gate prices fell by 0.7% year-on-year, marking the largest decrease since October 2020 when the COVID-19 pandemic began.
However, analysts generally believe that there is still a risk of a resurgence of inflation in the coming months.
The UK recently increased the energy price cap by 10%, which came into effect on October 1st according to regulations, and this will be reflected in the October CPI data. At the same time, the escalating conflicts in the Middle East and increased oil price volatility, along with public sector pay agreements, may also exacerbate the stickiness of wage growth.
"Inflationary pressures still exist," said Anna Leach, Chief Economist at the Institute of Directors in the UK, adding that how these different factors play out will ultimately determine the pace of interest rate cuts.
The UK has not yet effectively addressed issues such as weak supply-side growth and high living costs for residents, and the possibility of inflation recurring cannot be ruled out.
Positive for interest rate cuts and fiscal policy.In August, the Bank of England (BoE) cut its key interest rate for the first time since the beginning of 2020, lowering it by 25 basis points from a 16-year high of 5.25%. In September, the BoE chose to hold its position. The latest data shows a significant cooling of inflation, paving the way for the BoE to ease monetary policy in November.
BoE Governor Bailey, in a recent media interview, stated that if inflationary pressures continue to subside, the central bank's rate setters might become "more aggressive" in reducing the cost of borrowing.
Currently, traders are betting that the BoE will cut rates consecutively in November and December, whereas previously they anticipated only one rate cut.
ING's UK economist, James Smith, expects the decline in service sector inflation to be "big news" for the BoE, and the central bank may accelerate the pace of rate cuts after November, quickly entering a rate-cutting cycle.
The retreat of inflation provides greater room for both monetary and fiscal policies in the UK. Firstly, it provides a precondition for the BoE to cut rates. The market widely anticipates that the probability of the BoE cutting rates by 25 basis points in November exceeds 90%, and there is also a high likelihood of a further 25 basis point cut in December, with the benchmark rate expected to reach 4.5% by the end of the year.
Secondly, it alleviates the fiscal pressure on the UK government to some extent. As inflation in the UK continues to recede, the government's welfare spending linked to inflation is expected to decrease. At the same time, the BoE's rate cuts will reduce government interest expenditures, allowing the UK government to allocate more funds to achieve goals such as safeguarding household incomes, improving public service levels, and increasing infrastructure investment.
However, with the expectation of consecutive rate cuts by the BoE heating up, the pound may come under pressure in the coming months. Some institutions predict that, with the pound weakening and the dollar strengthening, the pound-to-dollar exchange rate may remain below the 1.30 level for the rest of the year.
As companies begin to release their third-quarter earnings, the focus shifts from macroeconomic data to the unfolding earnings season.
Lilian Chovin, Head of Asset Allocation at UK private bank Coutts, stated that what the UK stock market truly lacks for better performance and an upward trend is an improvement in earnings. However, from a macroeconomic perspective, the UK's performance in terms of economic data or recovery momentum is better than Europe's, and the current economic environment in the UK appears healthier.