Inflation boost comes at just the right time

In the United Kingdom, the decline in inflation continues despite higher petrol prices. This leaves the Bank of England with a difficult choice on Thursday: err on the side of caution or give the British economy some breathing space.

Anyone who had predicted three years ago that British inflation would now be 6,7% would have been considered crazy. But anyone who had made exactly the same prediction just a few weeks ago would have been dismissed as a dreamy optimist. That contradiction underlines the enormous change that the economic and inflationary environment has undergone in the United Kingdom. Particularly due to the consequences of Brexit, inflation is currently much higher than in the rest of the developed world. Because trade with the EU is more difficult and due to a shortage of seasonal workers who are deterred by stricter entry requirements, there has been a major shortage in certain parts of the British economy. This drives up prices relatively sharply.

Vegetables and fish are becoming cheaper
Prices for food and drinks in particular are significantly higher this year than in 2022. Earlier this year, inflation in this segment even reached 19%. In August that increase amounted to 13,6%. The prices of vegetables and fish, among other things, were even slightly lower than twelve months ago. Partly as a result, British inflation showed a small decline for the sixth month in a row. That was quite a surprise. Economists had expected that higher fuel prices would push inflation up to 7%. The unexpected decline presented the Bank of England (BoE) with a difficult choice: continue the fight against inflation as fiercely as ever or rather take a step back and give the economy some breathing space again.

Currency market looks at the short term
Ultimately, the BoE chose this afternoon not to raise interest rates for the fifteenth time in a row. It did not make much difference: four of the five board members did vote for an interest rate increase. Within two years, the policy interest rate has risen from 0,1% to 5,25%. This makes it more expensive – and therefore less attractive – for companies and consumers to borrow money. This reduces spending and investment, causing prices to fall and inflation to come under control. But even though inflation has been falling for six months, according to BoE Governor Andrew Bailey, it will take at least until spring 2025 before the target level of 2% is in sight. However, on the currency market, traders mainly focused on the short term.

Thanks to Barbie and Oppenheimer
The lack of an interest rate increase gave the pound the second consecutive decline in the past week. If high interest rates put too much of a brake on the economy in the coming months and the United Kingdom ends up in a recession, the BoE could choose to change interest rates well before 2025. In August, for example, consumer spending growth of 2,8% was already significantly lower than the 4,0% in July. And without a doubling of cinema spending – thanks to the success of Barbie and Oppenheimer – that difference would have been even greater. It will therefore be very interesting to see whether the pound suffers further damage after the next consumer spending publication in early October.

Joost Derks

Joost Derks is a currency specialist at iBanFirst. He has over twenty years of experience in the currency world. This column reflects his personal opinion and is not intended as professional (investment) advice.

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