Pound Sterling Upside Still Favoured After UK Inflation Heads in the "Wrong Direction"

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The British Pound initially retreated after news that UK inflation was as expected in November, but recent currency trends will not be challenged.

The Pound to Euro (GBP/EUR) showed a small yet clear decline after the ONS reported that UK headline CPI inflation rose to 2.6% year-on-year in November from 2.3% in October.

The increase confirms inflation is more likely to hit 3.0% before the Bank of England's 2.0% target.

However, it met market expectations, and for foreign exchange markets, expectations count. The Pound to Dollar (GBP/USD) eased to 1.2705, suggesting maybe the market was prepared for another upside surprise in the data, as was the case on Tuesday when UK wages caused some ripples in FX markets.

Also weighing on Pound Sterling was news that the CPI services rate was unchanged at 5.0%, which is lower than the market expected (5.1%).

Services inflation is where the most robust price pressures lie, and economists say this will ensure core inflation remains elevated and, in turn, headline CPI inflation.

For the Bank of England, services inflation must cool if it is to win the war on inflation. At 5.0%, it is still simply too high to warrant anything other than a cautious approach to lowering interest rates.

Indeed, the 5.0% reading is still higher than the Bank of England set out in its most recent forecast round (4.9%).

Above: Headline inflation is being held aloft by stubborn services inflation.

"These rates are well above those consistent with the 2.0% target and are currently moving in the wrong direction," says Paul Dales, Chief UK Economist at Capital Economics.

To be sure, the GBP's reaction to these data is relatively muted, which is expected when considering the broader message: inflation is rising again, and the Bank of England must remain vigilant.

This will bolster the view that the Bank won't cut rates on Thursday and will likely maintain a message that it will remain cautious.

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It will reference an ongoing slowdown in the UK labour market and economy, throwing up some 'dovish' tinges to proceedings, potentially weighing on the Pound.

But policy setters are boxed in by still-high services inflation, which might only rise further as UK wage pressures remain elevated. There is a transmission from higher wages to strong demand to increases in the prices charged by services businesses to customers.

"Even though activity has been weaker than the Bank expected, the stronger-than-expected rebounds in wage growth and CPI inflation published yesterday and today mean that the Bank won’t be able to worry less about inflation for a while yet," says Dales.

Recent data and Thursday's Bank of England outcome are unlikely to alter current FX trends that broadly favour GBP upside against European currencies and commodity currencies (AUD, CAD, NZD).