UK inflation causes the pound to plunge

The UK inflation data has surprised on the downside as concerns grow about Q3 growth

The UK inflation data has surprised on the downside. The headline CPI rate in the UK was 1.7% for September, below the 1.8% expected, and below the rate for the Eurozone. The biggest surprise in this data was the sharp moderation in service prices, which moderated to 4.9% from 5.6% YOY. This is the largest drop from one month to the next since the pandemic, and it suggests that the UK consumer has started the new school year with a frugal mind set. 

The largest downward contributors to inflation were petrol prices and hotels and restaurant prices, along with air travel and transport in general. Petrol price declines are the result of global forces driving the oil price, however, the decline in the price of hotels and restaurants suggests that people are scaling back on ‘experience’ spending, perhaps because Christmas is around the corner, or perhaps because they splurged too much on Taylor Swift over the summer months. The decline in airfares also suggests that the post pandemic boom in travel could be returning to more normalised levels. 

Either way, this was a shock reading, and it suggests that previous concerns about service price inflation have dissipated. 

Housing costs rose, as did food costs, however, there is a clear disinflation trend in the UK and this opens the door to an increase in bets that the BOE will cut interest rates in both November and December this year. The market is currently fully pricing in a rate cut in November, Gilt yields are tumbling. 2 year yields have fallen 10 basis points, the most since August. 

The pound has also sunk, and is below $1.30 vs the USD. It is currently trading around 1.2995, after dropping 0.6%. 

A daily close below $1.30 would be a bearish development for this pair. 

Overall, the picture painted by today’s CPI report and Tuesday’s labour market report shows a slowing economy in the UK at the end of Q3, that is starting to shed jobs, and one where inflation is falling. 

Should we worry about deflation? A dip below the target rate was expected, added to this a lot of the disinflation in the UK is generated by falling petrol prices, which is a global phenomenon as the oil price remains volatile. Service price inflation has fallen sharply, but is still well above the target rate and food prices have started to push higher once again. Thus, we don’t think deflation is a threat to the UK economy right now. Instead, the BOE should use this report to cut rates in November and December to get the UK economy over the current hump. After that it can revert to quarterly rate cuts. 

The pound is likely to struggle on the back of this data as it increases the chance of more BOE rate cuts over the next year. We think that sterling will remain sensitive to economic data in the coming weeks. Any downside surprises could weigh heavily on GBP, especially against the dollar. $1.30 is a key support level, but some weak economic data or a disappointing budget on the 30th, could send this pair plunging below this key level to the $1.27 level from late July.