By Pradeep Saran, September 21,2023
The Bank of England faces a critical decision regarding interest rates following an unexpected drop in UK inflation last month. Financial markets are now speculating that the central bank may opt to keep borrowing costs unchanged for the first time in nearly two years.
In a pivotal week for the economy, the August data released by the Office for National Statistics (ONS) on Wednesday led financial markets to adjust their forecasts. The likelihood of the central bank maintaining interest rates on Thursday increased from 20% to over 50%.
UK’s annual inflation rate decreased to 6.7% last month due to slower growth in food prices and monthly declines in hotel and air travel costs. This defied expectations from Threadneedle Street, City economists, and Chancellor Jeremy Hunt, who had anticipated a modest increase to 7%, primarily driven by rising petrol and diesel prices.
The latest dip in inflation, down from 6.8% in July, marks the sixth consecutive decline in the headline rate. It’s important to note that this doesn’t mean prices are decreasing; rather, they are rising at a slower pace.
The ongoing pressure on households due to the cost of living crisis is evident in the fact that food and drink prices increased by 13.6% in the year to August, although this is lower than their peak inflation rate of 19.1% earlier in the year.
Initially, the expectation was for a 15th consecutive interest rate hike on Thursday, involving a quarter-point increase to combat inflation and steer it back towards the Bank’s 2% target. However, with the central bank lending rate already at 5.25%, business leaders have voiced concerns about further rate hikes, given the economy’s weakening conditions. The private sector has cooled off in recent months due to reduced consumer spending and higher borrowing costs for companies. Additionally, unemployment has risen, and job vacancies have decreased.
Kitty Ussher, Chief Economist at the Institute of Directors, cautioned, “There are a number of red warning lights on the dashboard. Previous rate rises are working to tackle inflation. And if the medicine is working, you need to give it time to avoid risking an overdose.
“The ONS highlighted that the most significant impact on food and drink inflation came from milk, cheese, and eggs, with prices falling notably between July and August but remaining approximately 15% higher than a year ago. Prices of vegetables and fresh, chilled, and frozen fish and seafood also decreased during the month.
Core inflation, which excludes energy, food, alcohol, and tobacco, fell more than expected, dropping from 6.9% in July to 6.2% in August, primarily due to lower service prices. The Bank closely monitors figures for core inflation and the service sector when making interest rate decisions.
Last month, Threadneedle Street had anticipated a slight increase in inflation in August, followed by a sharp decline to around 5% in October.
James Smith, an economist at the Dutch bank ING, remarked, “We’re still tempted to say the Bank of England will hike rates. But it’s a close call, and both wage and inflation data suggest the end of the current tightening cycle is very close to its conclusion.
“Chancellor Hunt stated that the latest inflation figures indicated that the government’s plan was making progress. “But it is still too high, which is why it is all the more important to stick to our plan to halve it so we can ease the pressure on families and businesses. It is also the only path to sustainably higher growth,” said the Chancellor.
Despite the recent drop in inflation, the UK maintains the highest inflation rate among G7 economies. This occurs as major central banks worldwide conclude their most aggressive tightening cycles in decades. Many economists anticipate that borrowing costs will remain elevated to counteract persistent inflationary pressures.
Shadow Chancellor Rachel Reeves criticized the Conservative government, stating, “The prime minister is too weak to turn things around, while his predecessor, Liz Truss, continues to call for the same policies that crashed the economy this time last year. The Conservatives have wreaked havoc, and working people are paying the price.”