U.K. Inflation Running Hotter than Forecast

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- GBP rises after inflation surges in August, ahead of EU summit. 

- CPI rises from 2.5% to 2.7%, core-CPI rises back above 2% handle.

- EU summit and Brexit headlines will also be key to GBP price action.

Pound Sterling caught a bid Wednesday after official data showed U.K. inflation rising rapidly during August, placing the Bank of England under the spotlight.

The ONS reports inflation rose by 2.7% during August, up from 2.5% previously, when markets had looked for a decline to 2.4%. This takes the consumer price index even further away from the 2% target of the Bank of England.

Core inflation, which ignores volatile food and energy items so is seen as a more accurate representation of domestically generated inflation pressures, rose from 1.9% in July to 2.1% in August.

The Bank of England (BoE) has already raised its interest rate twice inside of the last year, to 0.75%, in order to combat rising levels of inflation and return the consumer price index to the 2% target.

These price dynamics suggest the Bank was right to make the move when they did and immediately raise questions on whether another hike should be brought forward.

Economists had expected the Bank to now sit on its hands until after Brexit takes place in March 2019 before raising rates again, but Wednesday's market reaction suggests some investors may now be reconsidering that assumption.

Markets care about inflation because it has implications for interest rates, which are themselves the predominant driver of exchange rates as global money tends to seek out higher returns.

And, it is inflation central banks are attempting to manipulate when they tinker with interest rates.

The data ensures Sterling holds onto its September rally:

Above: Pound-to-Dollar rate shown at daily intervals.

The Pound was quoted 0.35% higher at 1.3212 against the Dollar following the release after having extended an earlier 0.09% gain, while the Pound-to-Euro exchange rate converted a 0.20% loss into a 0.04% gain when it traded up to 1.1279.

Above: Pound-to-Euro rate shown at daily intervals.

"The pound jumped following this morning’s CPI figures, beating expectations and hitting a 10-week high against the Dollar. The Brexit outlook and developments in the critical phase of negotiations are still the main driver for the Pound’s performance, and with the number of short contracts in the market declining, there is scope for even further gains," says analyst Hamish Muress with brokers OFX in London.

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But, is this a Temporary Glitch?

However, we are certainly hesitant to call Sterling's reaction to the data a "surge" noting there are some signs that the pick-up in inflation might be temporary.

"The fact that the rise in inflation was driven by a pick-up in core CPI inflation (excluding food, energy, alcohol and tobacco) from 1.9% to 2.1% will raise fears that underlying inflation pressures are on the up again. But the increase in the core rate was driven by a sharp jump in the volatile theatre, airfare and clothing components which are likely to be temporary," says Ruth Gregory, a senior U.K. economist at Capital Economics.

Above: ONS graph detailing product contributions to inflation.

Rising prices of "recreational and cultural goods" as well as transport and other services were the greatest contributors to August's increase in inflation, according to the Office for National Statistics.

Transport costs rose at an annualised pace of 6% in August, largely due to increases in sea and air fares as well as fuel costs. Meanwhile, prices of theatre admissions, games, toys and hobby goods also increased notably.

Those upward pressures were part-parried by slower price growth for household goods such as furniture and telecommunications services. 

"The sharp rise in CPI inflation in August looks merely like a temporary deviation from its downward trend. The rise was driven partly by increases in the inflation rates in the volatile transport services and recreational goods sectors," says Samuel Tombs, chief U.K. economist at Pantheon Macroeconomics. "Transport prices are particularly sensitive to the particular day of the month the ONS collects its data, while recreational goods prices swing wildly when new blockbuster computer games are released."

Above: Pantheon Macroeconomics graph illustrating CPI correlation with Pound Sterling.

Tombs and the Pantheon team say consumer prices are still likely to fall back to the 2% target of the Bank of England of its own accord once into 2019, as the inflationary impact of the Pound's referendum-induced fall wanes further. The Capital Economics team have a similar forecast too. 

"The unexpected rise in CPI inflation from 2.5% to 2.7% (consensus 2.4%) came as a bit of a nasty surprise, but it does not alter our view that CPI inflation will be back at the 2% target by this time next year," says Gregory. "Given our expectation that CPI inflation will fall further and that earnings growth will gather some pace, we still think that a modest consumer spending recovery is in store, allowing the economy to re-gain some momentum."

What Really Matters for the Pound: EU Summit, Brexit Talks in Focus 

In addition to rising against the Euro and Dollar, Sterling converted losses to profits against around half the G10 basket following Wednesday's release.

"The data have surprised to the downside consistently recently, though Brexit headlines ahead of tomorrow's EU leaders meeting are more likely to drive GBP in the short-term," says Adam Cole, chief FX strategist at RBC Capital Markets.

European political leaders will meet in the Austrian city of Salzburg on Wednesday and Thursday to discuss resolving the bloc's migration crisis and the next steps to take in the Brexit negotiations.

The gathering takes place amid increased optimism and elevated hopes that an agreement on terms of the U.K.'s withdrawal from the EU can be reached ahead of or shortly after the October European Council summit. 

"GBP traders are looking ahead to the EU summit that is kicking off in Salzburg today with optimism. The Irish Prime Minister Leo Varadkar on the other hand sounded a little more cautious yesterday. He dampened expectations regarding the summit. No decision was going to be taken in Salzburg and he did not assume that the negotiating positions had changed," says Esther Reichelt, an analyst at Commerzbank. 

The EU's Michel Barnier said last week that a deal could be struck by early November after already having told a U.K. parliamentary committee he is open to considering alternative "backstop" proposals for how to manage the Northern Irish border if an agreement on the future relationship is not made during the transition period.

Barnier's optimism gave the Pound a fresh lease of life at the beginning of September, pushing the Pound-to-Dollar above 1.3100 this week, which was to be expected given the Northern Irish border has been a key sticking point in the talks. Sterling's response over recent days suggests investor angst about the trajectory of the negotiations may now be easing.

And in a further boost to those hoping for progress in the negotiations, The Times reported Monday that Brussels is now willing to consider proposals by Prime Minister Theresa May that technological solutions be used in order to manage the border between Northern Ireland and the Republic, which suggests at first glance there has been progress in the talks.

But a deal still needs to be agreed and while the EU's willingness to consider technological means for avoiding a hard border suggests there may have been some progress in the talks, it is not yet clear whether Brussels has dropped its push to effectively annex Northern Ireland into the regulatory and legislative orbit of the EU after Brexit.

"One thing is clear: despite the notably more conciliatory tone in recent days both sides still hold very differing positions on many important questions. So what will be decisive for Sterling at the summit is that no new red lines emerge during the talks," says Reichelt. "October will be the “moment of truth”. At that point it will become clear whether an agreement was in reach. The uncertainty as to what kind of agreement can be reached therefore remains in place for now, presumably also beyond the Salzburg summit. And as a result the risk of a Brexit “accident” also persists. As long as that is the case we cannot exclude that Sterling could trade at significantly lower levels again."

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