Economy

UK inflation dips below Bank of England target to 1.7%, opening door for potential interest rate cuts

UK inflation has dropped to its lowest level since April 2021, slipping below the Bank of England’s 2% target for the first time in years.

The latest data from the Office for National Statistics (ONS) shows annual inflation at 1.7% in September, down from 2.2% in August, a figure far lower than City analysts’ predictions of 1.9%. The Bank of England had forecast a more modest decrease to 2.1%.

The fall was largely driven by lower airfares and fuel prices, though this was partially offset by rising costs for food and non-alcoholic beverages, which saw their first increase since March 2023, climbing from 1.3% to 1.8%. This uptick in food prices, while notable, is far below the peak of nearly 20% in March.

Financial markets reacted quickly to the inflation news. Sterling dropped 0.62% against the US dollar, falling below $1.30, while it lost 0.49% against the euro, dipping to €1.194. In the bond market, the yield on the 10-year UK government bond fell by 1.8% to 4.1%, with the yield on two-year bonds dropping 2.5% to 4.03%, as expectations of interest rate cuts grew.

Darren Jones, Chief Secretary to the Treasury, welcomed the news but remained cautious: “It will be welcome news for millions of families that inflation is below 2 per cent. However, there is still more to do to protect working people, which is why we are focused on bringing back growth and restoring economic stability.”

This sharp decline in inflation could provide Chancellor Rachel Reeves with a crucial advantage as she prepares her first budget on October 30. The fall increases the likelihood of faster interest rate cuts by the Bank of England, a move that could support her plans to close a £40 billion fiscal gap. Speculation is growing that the Chancellor may introduce capital gains tax increases and impose national insurance on employers’ pension contributions as part of the budget.

Grant Fitzner, ONS Chief Economist, noted: “Inflation eased in September to its lowest annual rate in over three years. Lower airfares and petrol prices were the biggest driver for this month’s fall. These were partially offset by increases for food and non-alcoholic drinks.”

The lower-than-expected inflation figure will have significant ramifications for benefit payments, which are adjusted annually based on September’s inflation rate. A smaller rise in benefits could result, while the so-called “fiscal drag” from wage increases pushing workers into higher tax bands may ease slightly. However, the state pension is still poised to rise by £460 next year, thanks to strong wage growth over the summer.

The drop in inflation marks a significant moment in the UK’s battle against surging prices, which peaked at 11.1% in October 2022, driven by soaring energy costs following Russia’s invasion of Ukraine. Even before the war, inflationary pressures were mounting due to post-pandemic supply issues and strong consumer demand, leading prices to rise by more than 20% since 2021.

The Bank of England responded to this inflationary surge by steadily raising interest rates, beginning in December 2021. However, after maintaining elevated rates for several years, it cut rates in August for the first time since 2018. With inflation now below target, many economists are predicting another rate reduction at the Bank’s next Monetary Policy Committee (MPC) meeting on 7 November.

Paul Dales, Chief UK Economist at Capital Economics, commented: “A rate cut next month already seemed nailed on before the September inflation figures, but the chances of that being immediately followed by another 25 basis points cut at the following meeting in December have just gone up.”

Thomas Pugh, economist at RSM UK, added: “This data provides clear evidence that disinflation is continuing to move through the economy at pace, and should reassure the Bank of England that it can move to cut interest rates more aggressively without stoking higher inflation.”

However, not all MPC members are convinced. The committee remains divided over the persistence of inflationary pressures, with Governor Andrew Bailey signalling that the Bank could take a “more aggressive” approach to easing policy, while Chief Economist Huw Pill has argued for keeping rates higher for longer to combat entrenched inflation.

Services inflation, a key measure for the Bank, dropped sharply from 5.6% in August to 4.9% in September. Core inflation, which strips out food and energy prices, also declined, falling from 3.6% to 3.2%, further fuelling speculation that more rate cuts are on the horizon.

As the Bank of England faces increasing pressure to ease borrowing costs, it’s clear that the debate over the speed and timing of rate cuts will intensify in the coming weeks. With MPC votes often tightly contested, the path to lower interest rates remains anything but certain.

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