Unfolding UK inflation and Bank of England rate policy: A comprehensive overview

The United Kingdom is grappling with a surge in inflation, hitting 4.0% over the 12 months up to December 2023. This is a climb from the 3.9% noted in November and the first increase since February 2023. Looking at monthly variations, the Consumer Prices Index (CPI) went up by 0.4% in December 2023, reflecting the same rate as December the previous year.

Contributing factors: Tobacco and alcohol

The main factor for the monthly shift in CPIH (Consumer Prices Index including owner occupiers’ housing costs) and CPI annual rates was the price hike in alcohol and tobacco. The increase in tobacco prices mainly stemmed from a rise in tobacco duty after the government announced higher taxes in the autumn statement. Tobacco prices jumped 4.1% from November to December, resulting in a significant yearly increase of 16.0%. On the other hand, alcohol prices dropped by 1.6% in the same timeframe, contributing marginally to the overall annual rate increase.

Inflation outlook and fiscal stimulus

Historical data from 2005 to 2023 shows a pattern of UK inflation typically slowing in January compared to the previous December. Despite the unexpected increase in December 2023, analysts are forecasting a likely slowdown for January, with the official figures expected to be released in February.

It’s expected that services inflation will continue in the short term, largely depending on the extent of any fiscal stimulus revealed in the March budget. Governor Andrew Bailey might choose to be cautious before deciding to lower rates, considering the ongoing increase in wages and services prices. Furthermore, the possibility of significant spending by the UK government complicates the decision-making scenario.

Minimum wage increase and inflation concerns

A major concern contributing to inflation is the upcoming 9.8% rise in Britain’s minimum wage, set to hit 11.44 GBP per hour in April 2024. This hike places the UK's minimum wage among the top in advanced economies and could contribute to inflationary pressures.

Two key elements likely to accelerate the decrease in inflation are energy prices and a rollback of the widespread price increase witnessed in spring 2023.

Bank of England’s rate policy: Awaiting data

The Bank of England is set to consider rate cuts after March, eyeing the May Monetary Policy Report as a significant turning point. By then, the central bank is anticipated to have collected enough data to make well-informed decisions, taking into account the changing economic scenario.

Source: ONS, Deriv

GBP/USD outlook and expert opinions

The GBP/USD exchange rate has been under close scrutiny. HSBC’s Dominic Bunning has criticised the sterling’s surge from 1.20 USD to 1.27 USD in late November, deeming it unwarranted given the interest rate differences. Bunning anticipates a possible decline of the sterling to around 1.20 USD in 2024, attributing this to underlying weaknesses in the British economy.

JP Morgan predicts the sterling/dollar pair to drop to 1.18 in the first quarter of 2024, with a recovery to 1.26 expected by December. The main influences on this forecast are the dynamics between inflation and subdued growth in 2024, which are set to steer the Bank of England’s policy choices.

Economic performance and resilience

Latest economic figures show a dip in output, indicating a 0.1% decrease in Quarter 3 (July to Sept) 2023, adjusted from an initial estimate of no growth. This comes after a stagnant Quarter 2 (Apr to June) 2023, which was initially projected to rise by 0.2%.

In summary, the current situation in the UK represents a multifaceted mix of inflationary pressures, sluggish economic growth, fiscal factors, upcoming general elections, and central bank policy decisions.