UK Inflation Fell Below Target in January but the Bank of England Won't be Swayed say Economists

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- Inflation falls below target in January for first time in two years.

- As petrol and Ofgem cap weigh on main consumer price index.

- But high "core inflation" will keep BoE on track to raise rates.

Inflation fell beneath the Bank of Engand (BoE) target in January for the first time in two years, although consumer price pressures are still too high for many economists, who say interest rates will rise in the coming months as a result.

The consumer price index fell to 1.8% in January, from 2.1% previously, when economists had looked for a decline to only 1.9%. However, the move was in line with the BoE forecast for this month. 

Inflation was dragged lower as a steep decline in oil prices that took place late last year appeared in petrol prices charged at the pumps, while Ofgem's new energy price cap was also seen weighing on the index.

"The return of inflation to below the 2% target for the first time in two years is welcome news for households, but a further substantial fall isn’t likely," says Samuel Tombs, chief UK economist at Pantheon Macroeconomics. "This reflected the imposition of a new cap on Standard Variable Tariffs, which was 6% below prior average levels. Ofgem, the energy regulator, however, announced last week that the cap will rise by 10% in April, which will boost the headline rate of CPI inflation by 0.3pp."

Core inflation, which is seen as a truer representation of domestic price pressures because it removes volatile energy and food items from the goods basket, remained at 1.9% for a second consecutive month. 

The core measure is now in the process of reversing its 2018 decline to 1.8% and the Bank of England has said repeatedly it expects the index to remain biased toward the upside for some time to come. 

"The recent pick-up in wage growth likely will filter through to services inflation, which ticked up to 2.5% in January, from 2.4% in December. We expect core inflation, therefore, to continue to continue to hover only slightly below the 2% target during 2019, before rising in 2020 as the tight labour market generates more cost pressures for firms," Tombs adds. 

Changes in interest rates are normally only made in response to movements in inflation but are important for financial markets because of the push and pull influence they can exert over international capital flows. 

Consumer price changes are important for the economy because inflation is a subtraction in the calculation of real GDP growth, so rising price pressures can depress economic growth and vice versa. 

"We think stronger pay pressures will eventually show up in the inflation data. As a result, we continue to think the Bank of England would press ahead with interest rate hikes if a Brexit deal is reached despite today’s slip in inflation below target," says Andrew Wishart, an economist at Capital Economics. 

The Bank of England said this month that UK economic growth will likely slow further in 2019 given weakening demand from overseas and a period of increased "Brexit uncertainty" that are expected to reduce activity in the UK. 

It still maintained the line that interest rates will need to rise "at a gradual pace and to a limited extent" over the coming years in order to ward off mounting price pressures, but the lower GDP and inflation forecasts led markets to believe the BoE thinks rates will rise by less than was previously the case.

"With inflation fairly well behaved, the Bank will also have the ability to support the economy by cutting interest rates if there were a no deal Brexit," says Capital Economics's Wishart. 

Brexit pandemonium in parliament and uncertainty over the shape of the UK's future relationship with the European Union is the only thing keeping the Bank of England from raising rates again, most economists say, given the UK is due to depart the EU on March 29. 

Prime Minister Theresa May says she is attempting to negotiate a replacement of the so-called Northern Irish backstop in the EU Withdrawal Agreement, as MPs rejected her proposed exit plan in a record breaking landslide last month. 

However, it was widely reported on Tuesday that the PM simply intends to offer MPs a second vote in late February where the choice is between approving the Withdrawal Agreement and a lengthy delay to the UK's departure from the bloc. 

If the Withdrawal Agreement is not ratified before March 29 then the UK will automatically leave the EU and default to doing business with it on World Trade Organization (WTO) terms, which analysts say would be bad for the economy.

The Bank of England has already raised interest rates on two occassions in the last 18 months, taking the bank rate up to 0.75%, in order to combat the sharp increase in inflation that resulted from the vote to leave the European Union. 

UK inflation rose from 0.5% in June 2016 to 3.1% by November 2017 and core inflation increased from 1.4% to a peak of 2.7%. A double-digit devaluation of Pound Sterling that increased the cost of imported goods for consumers, and a strong labour market were seen behind the pick up. 

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