In September, UK inflation dropped to 1.7%, descending below the Bank of England’s target of 2%. This shift has heightened speculation regarding potential interest rate reductions.
This figure, the lowest since 2021, diverges from analysts’ expectations and introduces new dynamics in financial markets.
The Office for National Statistics reported a drop in annual inflation from 2.2% in August to 1.7% in September. This decrease was unexpected, as analysts had predicted a more slight reduction to 1.9%.
The inflation decline was primarily driven by reduced airfares and fuel prices. However, there was a notable increase in food and non-alcoholic beverage costs, rising from 1.3% to 1.8% since March 2023.
Following the inflation report, the sterling depreciated by 0.62% against the US dollar and 0.49% against the euro. Such fluctuations are indicative of market reactions to potential shifts in monetary policy.
Bond markets also responded, with yields on 10-year UK government bonds falling by 1.8% to 4.1%. Meanwhile, two-year bond yields decreased by 2.5% to 4.03%, reflecting growing expectations of interest rate cuts.
The inflation reduction presents an opportunity for Chancellor Rachel Reeves in her budget preparations, which aims to address a £40 billion fiscal gap.
With inflation below target, Chancellor Reeves might consider capital gains tax increases or taxing employers’ pension contributions.
The Bank of England could see this as an opening to cut interest rates more aggressively, potentially as early as their November meeting.
Economists are increasingly convinced about the potential for further interest rate cuts. Paul Dales, Chief UK Economist at Capital Economics, suggested that the likelihood of an imminent rate cut is high.
Thomas Pugh from RSM UK added that the data reaffirms the continuation of disinflation, enabling the Bank to consider lowering rates without exacerbating inflation.
Despite optimism from some analysts about rate cuts, the Monetary Policy Committee remains divided on how quickly rates should be reduced. Governor Andrew Bailey is more open to easing, while Chief Economist Huw Pill remains cautious.
Service sector inflation rates fell sharply, alongside a decrease in core inflation from 3.6% to 3.2%, further fuelling debates.
The lower inflation rate might impact benefit payments, potentially leading to smaller increases. However, the state pension is expected to rise due to significant wage growth last summer.
The inflation drop highlights a pivotal change from last year’s peak, influenced heavily by external factors such as energy prices and geopolitical tensions.
The Bank of England has been proactive in managing inflation through interest rate adjustments, which started rising in December 2021.
As the UK navigates economic recovery post-pandemic, the path to sustainable growth remains complex, with interest rate decisions being a critical aspect.
The decline in inflation below the Bank’s target presents both opportunities and challenges in economic policy. As debates on interest rates intensify, the focus remains on balancing inflation control with economic growth initiatives.
