UK inflation hits 3.5 percent as fuel costs drive rate hike expectations

Inflation in the United Kingdom accelerated to 3.5 percent in the 12 months to September, exceeding market forecasts and marking the highest annual rate in almost a year. The increase was primarily driven by a sharp rise in the cost of motor fuels, which pushed the overall figure above the 3.4 percent average predicted by economists polled by Reuters. This latest data point continues an upward trend in price growth, following readings of 3.1 percent in August and 2.9 percent in July.

The Office for National Statistics reported that motor fuel prices surged 29.8 percent in the year to September, reaching their highest level since August 2022. That previous peak occurred in the wake of Russia’s full-scale invasion of Ukraine, which caused a significant spike in global energy costs. As a net energy importer, the United Kingdom remains vulnerable to external shocks, including the recent conflict between the United States and Iran and the subsequent difficulties in moving oil through the Strait of Hormuz. These geopolitical factors have contributed to the current pressure on consumer prices.

Market reaction to the data was muted, with the British pound remaining flat against both the euro and the US dollar. Yields on UK government bonds also saw little change. However, financial markets are increasingly confident that the Bank of England will respond to the inflationary pressure. According to LSEG data, traders are pricing in a 98 percent probability that the central bank will raise its key interest rate by 25 basis points to 4.0 percent at its next meeting. The majority of market participants also expect a further hike of the same magnitude at the final meeting of the year in December.

Scott Gardner, an investment strategist at J.P. Morgan Personal Investing, noted that recent growth in headline inflation has undone progress made in the spring. He highlighted that services inflation has accelerated in recent months, raising concerns about second-round inflationary effects beyond energy prices. Gardner argued that while the current challenges differ from those in 2021, the prolonged conflict is weighing on the economy and strengthening the case for a rate increase.

The inflation data also complicates the fiscal outlook for the UK government. Chancellor of the Exchequer John Healey is scheduled to unveil his first fiscal update next week during the Autumn Budget. He faces the challenge of adhering to previous fiscal rules aimed at rein in public debt while delivering support to soften the blow of rising consumer costs. Separate data published on Wednesday indicated that the UK’s national debt exceeded three trillion pounds for the first time in September. The cost of servicing these debts has risen sharply over the past year, while the economy struggles to grow.

In a statement, Healey said he would maintain fiscal discipline while working to drive growth and provide breathing space for businesses and families. Suren Thiru, chief economist at the Institute of Chartered Accountants in England and Wales, described the situation as a perilous balancing act. He warned that surging prices are increasing pressure for cost-of-living support while pushing up borrowing costs, thereby shrinking fiscal headroom. Thiru concluded that the pieces are falling into place for a November rate rise, with policymakers looking to the Chancellor to avoid adding fuel to the inflation fire.