Inflation Back at BoE’s Target in 1H of Next Year?

The pound has sustained its weakened position following a significant downturn yesterday, spurred by the release of the latest UK CPI report for November. This has led to EUR/GBP climbing back up to the 200-day moving average around 0.8660, while cable has retreated to levels observed immediately after last week's FOMC meeting, ranging between 1.2600 and 1.2650. The substantial sell-off in the pound was anticipated given the extent of the negative inflation surprise in the UK. According to Bloomberg, it marked the most significant downside surprise for the annual rate of headline inflation since the release in March 2021 and the largest downside surprise for the annual rate of core inflation since the release in September.

In the first hour post the release of the latest CPI report yesterday, EUR/GBP saw a +0.43% increase, representing the most substantial reaction to a UK CPI report over the past year since the release in February. The primary reason behind the intensified pound sell-off triggered by the latest UK CPI report is that it challenges the notion that the Bank of England (BoE) will trail behind other major central banks such as the ECB and Fed in initiating rate cuts next year. Previously, it was believed that persistent inflation risks were more pronounced in the UK, making the BoE comparatively more cautious about rate cuts. However, there is now mounting evidence that inflation in the UK is decreasing rapidly, like trends observed in the US and the euro-zone, albeit with a time lag.

The annualized rate of core inflation in the UK over the last six months has sharply declined to 2.4% in November, down from its peak of 9.6% in July. While monthly data in the UK can be more volatile, the recent improvement in underlying inflation measures is becoming harder for Monetary Policy Committee (MPC) members to dismiss. Additional positive news emerged yesterday when Cornwall Insight forecasted a 14% reduction in Ofgem's cap on domestic energy bills in April next year, reflecting the decline in wholesale gas prices since mid-November. These favourable developments are reinforcing market expectations that headline inflation could retreat to the BoE's 2.0% target in the first half of next year, paving the way for the BoE to commence rate cuts from Q2.

Although aligned with my current BoE policy forecasts, the accelerated decline in inflation poses downside risks to my short-term pound predictions. The faster-than-expected decrease in inflation could impact the near-term performance of the pound against other currencies. As the BoE's cautious approach comes into question, investors are reassessing their expectations, particularly in comparison to the more proactive stances of the ECB and Fed. The recent surge in EUR/GBP immediately after the CPI report release underscores the market's re-evaluation of the BoE's position.

Moreover, the recent favourable developments, such as the anticipated decrease in domestic energy bills, are contributing to the growing belief that the UK's headline inflation will align with the BoE's 2.0% target in the first half of the coming year. This, in turn, sets the stage for potential rate cuts by the BoE from the second quarter onwards. Despite this alignment with my current forecasts for BoE policy, the swifter decline in inflation introduces an element of uncertainty, warranting careful monitoring of economic indicators and policy statements for any shifts in market sentiment.

In conclusion, the aftermath of the UK CPI report has triggered a cascade of reactions in the currency markets, with the pound facing increased pressure due to unexpected inflation dynamics. The evolving narrative challenges the previously held belief in the BoE's cautious stance, opening the door for potential rate adjustments soon. The intersection of economic data, central bank policies, and market sentiment will continue to shape the trajectory of the pound, necessitating a vigilant approach for investors and analysts alike.

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