UK Inflation Beats Expectations but 2020 Bank of England Rate Cut Cannot Be Ruled Out

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- UK inflation holds at 1.5%, core inflation steady at 1.7%.

- Figures meet expectations but BoE outlook is still souring.

- A slowing economy could undermine UK inflation next year.

- Johnson's Brexit gambit sees uncertainty continue in 2020.

- BoE warned in November of rate cut response to uncertainty.

UK inflation figures beat market expectations on Wednesday but price growth is still running below the Bank of England (BoE) target and recent political developments are making a 2020 interest rate cut more likely regardless. 

Office for National Statistics data revealed Wednesday that inflation remained at 1.5% in November when markets were looking for a decline to 1.4%. Core inflation, which is seen as a more reliable indicator of domestically generated inflation pressures, remained at 1.7% in line with expectations.

"The unchanged rate of inflation was a little above the projection made by the Bank of England in November and the consensus forecast of 1.4%," says Ruth Gregory at Capital Economics. "With inflation well below target, little sign of underlying price pressures and GDP growth running below trend, an interest rate cut on Thursday shouldn’t be completely ruled out."

Core inflation, which eliminates volatile energy items from the consumer goods basket as well products which have regulated prices (tobacco and alcohol) that can distort underlying trends in organic inflation, has been below the 2% target since August 2018 when the BoE lifted Bank Rate to 0.75%.

And the headline rate of inflation has fallen from 2.1% in July to leave both consumer price indices sitting below the 2% target of the BoE which, when combined with the current economic and political outlooks, could have implications for interest rates over the coming months.

Markets care about inflation statistics because central banks are obliged to use interest rate policy to keep price growth contained within preset parameters. The BoE's target is to ensure the consumer price index averages 2% over the medium-term, but inflation is sensitive to growth which means the pulse of the economy is important to the outlook for both prices as well as rates. 

"The MPC, however, likely will remain focussed on domestically-generated inflation, which we expect to continue to strengthen modestly, in response to the tight labour market and likely uptick in GDP growth in the first half of 2020. We continue to think, therefore, that investors are mistaken currently to be pricing-in a 50% chance that the MPC will cut Bank Rate in the first half of next year," says Samuel Tombs, chief UK economist at Pantheon Macroeconomics. 

UK inflation declines have come against the backdrop of a stalling economy and given this week's fresh dose of Brexit uncertainty, could be enough of an incitement to get the Bank of England talking about a 2020 interest rate cut on Thursday and after subsequent meetings, which might further weigh on the Pound. The BoE will announce its next rate decision at 12:00 Thursday and markets are not yet prepared for a rate cut.

The UK economy is widely thought to have slowed further in the final quarter of the year when it was already on track to miss the market consensus for GDP growth of only a paltry 1.3% for the year overall. IHS Markit PMI surveys are pointing to a final quarter contraction and with the economy up just 0.8% for 2019 at the beginning of the period, it'd take a very strong finish to the year for the UK to meet the consensus for growth.

"Coupled with yesterday’s robust labour market figures the pressure on the MPC to cut interest rates at its meeting tomorrow appears to have eased somewhat. We continue to expect the MPC to keep rates on hold at 0.75% on Thursday and for some time to come," says Capital Economics' Gregory. 

Pricing in the overnight-index-swap market implied a Bank Rate of 0.70% will follow Thursday's meeting, which is below the current 0.75% but far above the 0.5% that would prevail after a typical 25 basis point cut. 

That suggests there's little chance of action this week but this doesn't mean that a cut can be ruled out for the months ahead.  

The market-implied rate for April 2020 was 0.64% on Thursday, again below the current 0.75% level and also above the 0.5% that would prevail in the wake of a typical cut so any suggestion from the BoE on Thursday or over that coming weeks that rates could be cut would see the implied rates for 2020 fall and likely drag the Pound lower with them.

But any cuts announced over the coming months may be motivated more by ongoing political uncertainty and the impact it's having on the inflation outlook. 

The BoE said in November that it if the global economy does not stabilise in the months ahead and that if "Brexit uncertainties remain entrenched" then it might need to cut interest rates in order to "reinforce the expected recovery of UK GDP growth and inflation". And this week has brought with it a strong indication that such Brexit uncertainties are set to endure throughout the year ahead . 

"We can't see why some members of the Committee would want to exhaust that bullet now as opposed to well into 2020, when the likely outcomes of various UK trade negotiations should be clearer," says Stephen Gallo, European head of FX strategy at BMO Capital Markets. "Having said that, we don't anticipate that the OIS-implied expectations for the benchmark rate will change materially from their current levels this week."

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