Unexpected Drop in UK Inflation Sparks Doubts About Bank of England's Interest Rate Strategy

21 Sep, 2023

Unexpected Drop in UK Inflation Sparks Doubts About Bank of England's Interest Rate Strategy

Surprisingly, the United Kingdom experienced a decline in its inflation rate for August, as revealed in official data on Wednesday. This unexpected development has led to uncertainty regarding the Bank of England's upcoming interest rate decision, scheduled for the day after the data release.

The consumer price index fell from 6.8% in July to 6.7%, defying both economists' predictions, as per a Reuters poll, and the Bank of England's expectations for an increase. This unexpected drop in the inflation rate, the lowest since February 2022, had a significant impact on the currency market, causing the pound to reach its lowest point against the U.S. dollar since May. The pound also weakened against the euro as investors reduced their bets on future interest rate hikes by the Bank of England.

The Office for National Statistics attributed this decline to several factors, including lower hotel prices and airfare costs (which are often volatile) and slower food price increases compared to the same period last year. These factors offset the rise in fuel prices and an increase in taxes on alcoholic beverages.

In the previous month, the Bank of England had projected that August's inflation would reach 7.1% before sharply declining to around 5% in October, which would still be well above its 2% target. Investors had anticipated the Bank of England would raise interest rates for the 15th consecutive time on Thursday, moving the Bank Rate from 5.25% to 5.5%. However, the inflation data has cast doubt on this expectation. Investors now estimate about a 45% chance that the Bank of England will pause its rate hikes on Thursday, up from the previous estimate of about 20% prior to the release of the inflation figures.

Core inflation, which excludes volatile food and energy prices, also decreased more than the headline rate, falling from 6.9% in July to 6.2% in August, contrary to the Reuters poll's prediction of 6.8%.

Price growth in the UK's service sector, closely monitored by the Bank of England, also slowed to 6.8% in August from 7.4% in July.

These numbers not only provide some relief to the Bank of England, which faced criticism when inflation exceeded 11% in October of the previous year, but they also align with the objectives of Prime Minister Rishi Sunak's government. Sunak had made a commitment to reduce inflation by half this year, particularly in anticipation of the expected 2024 election. Finance Minister Jeremy Hunt commented, "Today's update demonstrates that our strategy to address inflation is delivering results – plain and simple. However, it remains at an elevated level, which underscores the importance of adhering to our plan to reduce it by half, thus alleviating the burden on families and businesses. This remains the only viable path to achieving sustainable economic growth