Service Sector Inflation Spooks Markets ... Hits Rates Hopes ...

Headline CPI inflation picked up sharply to 2.3% in October, spooking markets and lowering expectations of a December interest rate cut.

The jump marked a sharp increase from the 1.7% rise recorded in September, exceeding the 2.2% forecast of economists polled by Reuters.

The latest data brings inflation back above the Bank of England's 2% target, dampening the prospects of a final interest rate cut this year.

Core inflation, which excludes energy, food, alcohol and tobacco, came in at 3.3% for the month, up slightly from 3.2% in September. The uptick was due in part due to an increase in the energy price cap that took effect in October.

CPI goods annual rate increased from minus 1.4% to minus 0.3%. Goods inflation continues to subsidise the headline rate. Price rises in the U.K.'s service sector ticked up to 5.0% from 4.9% in September, a major cause for concern for the MPC.

Speaking before the Treasury Select Committee earlier this week, Governor Andrew Bailey said that inflation in the UK's services sector remained too high and was incompatible with bringing prices back to 2 per cent.

The increase in minimum wage and the changes to National Insurance costs are likely to maintain price pressures into the New Year, especially in the service sector.

The governor warned "The introduction of higher national insurance tax on employers poses uncertainty for future interest rate cuts."

"The increase in employers' national insurance contributions announced in last month's budget was one of the biggest uncertainties ahead".

"There are different ways in which the increase in employers' national insurance contributions announced in the autumn budget could play out in the economy," Bailey said.

"If it raised the cost of employment and led to job cuts, it would soften the labour market and force the Bank to lower rates gradually", he said.

"On the other hand, if the increase in costs was passed through to higher prices, the MPC would be forced to address the increase in inflationary pressure. The increase in employers' national insurance contributions could keep rates higher for longer."

"A gradual approach to removing monetary policy restraint will help us to observe how this plays out, along with other risks to the inflation outlook."

His warning came after major retailers wrote to the chancellor Rachel Reeves warning that shops will close, jobs will be lost and prices will have to rise because of the decision to raise employers' NICs in the budget. Economists estimate that future job losses will be in the range of 80,000 to 100,000 over the next five years.

The Bank expects inflation CPI to peak at around 2.8% in the third quarter of 2025 before returning to the 2% target in 2027. Market expectations of base rate trends have risen with six month gilts trading at 4.5%, ten year gilts trading at 4.4% at close of week.

The Bank's favoured OIS overnight swap rates are trading at 4.5% to 4.0% on a six month to ten-year spread. As of Wednesday morning, markets were pricing in just a 14% chance of a further quarter point cut this year. We expect a move to 4.5% as the next bank move but not until the end of the first quarter in 2025. Then not much more after that.

Borrowing figures this week will do nothing to ease pressure on gilt yields. Thursday's ONS release revealed borrowing in the first seven months of 2024-25 was £96.6 billion. This was £1.1 billion above the same period last year. 

The year-on-year increase was driven primarily by higher central government spending, particularly departmental consumption expenditure and welfare spending. Strength in receipts compared to last year has offset a significant portion of the higher expenditure, the OBR said.

Borrowing for the whole of 2024/25 is expected to be £2.4 billion higher than last year, £127.5 billion compared to £125.1 billion in 2023/24. The Debt Management Office will be looking to find a home for £300 billion of gilts, including roll overs, in the current financial year. Let's hope the kindness of strangers persists.

The prospect of higher rates did nothing for Sterling this week. The Dollar bounce back continued, pushing the Pound to $1.25, down from the heady heights of $1.34 in September. The Euro cross rate closed at $1.04 as a Dollar push to parity comes into play.

Bitcoin traded at $99,352 intra day yesterday. Maybe a tree (or a tulip bulb) can hit the sky ...