UK Inflation Plummets to 1.7% – First Time Below Bank of England’s Target in Over Three Years

The UK’s inflation rate has sharply dropped to 1.7% in September, marking the first time it has dipped below the Bank of England’s (BoE) target of 2% since April 2021. This significant drop, reported by the Office for National Statistics (ONS) on Wednesday, has far-reaching implications for the British economy and financial markets, with the possibility of further interest rate cuts in the near future.

Unexpected Drop in Inflation

The 1.7% inflation rate came in lower than the 1.9% forecast by economists polled by Reuters. This reduction signals that the UK is moving into a more moderate inflation environment, a sharp contrast to the inflationary pressures witnessed over the past few years. Fuel prices, which have been on a steady decline, played a significant role in this reduction, alongside the easing of price rises in the services sector, which is a key component of the UK economy.

According to Suren Thiru, economics director at the Institute of Chartered Accountants in England and Wales (ICAEW), this notable drop in services inflation highlights that “underlying price pressures are becoming less sticky.” However, Thiru also cautioned that inflation could reverse its course in October due to the anticipated increase in the energy price cap, set by regulators.

Impact on Interest Rates and Monetary Policy

The sharp drop in inflation has fueled expectations of additional rate cuts by the Bank of England. Money markets are now pricing in a 91% chance of a 25-basis-point rate cut in November, up from 80% before the inflation data was released. This would bring the BoE’s key interest rate down to 4.5%. Analysts also suggest that a follow-up rate cut in December is almost certain, which would complete two quarter-point reductions by the end of 2024.

Sanjay Raja, Chief UK Economist at Deutsche Bank, described the inflation figures as "music to the [Monetary Policy Committee’s] ears," suggesting that the BoE may now consider unwinding restrictive policies more quickly. Raja also pointed out the potential risks posed by the upcoming UK Labour government’s budget, which is scheduled for October 30. The budget, likely to be expansionary, could present inflationary challenges that may delay the BoE's plans for further rate cuts.

Currency and Bond Market Reaction

The release of the inflation data had an immediate impact on the UK financial markets. The British pound fell by 0.6% against the U.S. dollar, dropping below the $1.3 level for the first time since early September. The pound also dropped 0.5% against the euro, signaling more dovish expectations for the Bank of England’s monetary policy.

Additionally, UK government bonds, known as gilts, saw a decline in yields across the board. Two-year gilt yields fell by 9 basis points, while 10-year gilt yields dropped by 7 basis points. These movements reflect the growing consensus among investors that interest rates will continue to decline in response to the easing inflation.

Challenges Ahead: Energy Price Cap and Economic Uncertainty

Despite the positive news, experts caution that the UK is not out of the woods yet. The drop in inflation was partially driven by a fall in airfares, and economists, including Paul Dales of Capital Economics, warn that this is a temporary factor. Dales highlighted that core inflation and services inflation remain key metrics for the BoE’s decision-making. In September, core inflation, which excludes volatile categories like energy and food, fell to 3.2%, down from 3.6% in August. However, this figure is still well above the BoE’s 2% target.

Dales also suggested that while the BoE may continue with 25-basis-point cuts in the near term, the long-term outlook could see interest rates falling as low as 3.00%, lower than the 3.5-3.75% currently priced into the market.

Additionally, the UK's energy price cap is set to rise in October, which could drive inflation back up. This, combined with the upcoming budget, poses risks for the BoE’s inflation outlook. While lower inflation is generally good news for consumers and businesses, there remains uncertainty around the potential economic impact of fiscal policies that may be introduced later this month.

Conclusion: Inflation Cooling, but Challenges Remain

The UK’s inflation rate falling to 1.7% is a significant development and offers hope that the country is entering a more stable inflationary environment. However, with potential reversals due to energy prices and fiscal policies, the Bank of England remains cautious about the path forward. The expectation of further interest rate cuts will provide some relief to businesses and consumers, but long-term economic stability will depend on how the government and central bank manage upcoming challenges.

The situation remains dynamic, and all eyes will be on the BoE’s November meeting, where further decisions on interest rates and monetary policy will be made.