United Kingdom: The Bank of England faces a difficult choice

• Headline inflation increased from 2.6% to 2.9% year-on-year.
• Core inflation remained at 2.6%, above the 2.5% forecast.
• Services inflation held at 3.4%, instead of rising to 3.5%.
• Wage growth slowed, while unemployment benefit claims increased by 27,800.
• The Bank of England is expected to leave interest rates unchanged tomorrow.
• Energy pushes headline inflation higher

UK consumer price inflation accelerated from 2.6% to 2.9% year-on-year in August, in line with market expectations. Core inflation delivered a slightly stronger reading, remaining at 2.6% against expectations for a decline to 2.5%. The figures confirm that price pressures in the British economy remain relatively persistent.

The increase in headline inflation was driven mainly by energy prices, including more expensive fuel. This is particularly important given the continued rise in global oil prices. Following the Houthis’ advance in Yemen, crude oil is moving towards USD 110 per barrel, increasing the risk that UK inflation will remain above the Bank of England’s target for longer.

For the Bank of England, indicators of domestic price pressure are more important than the headline CPI figure alone. Core inflation remained at 2.6%, while services inflation was unchanged at 3.4%. The latter was slightly better than some forecasts, which had pointed to an increase to 3.5%.

Airfares also had a smaller impact than expected. Prices increased by 6.2% compared with July, but this was not enough to push services inflation higher.

The data therefore suggest that rising energy costs have not yet generated significant second-round effects. In other words, higher fuel and energy prices are not visibly spreading into wages and other service-sector categories.

The latest labour market figures provide a similarly mixed picture. Average weekly earnings increased by 3.9% year-on-year in July, in line with forecasts but below the previous month’s growth rate of 4.2%. Regular pay growth, excluding bonuses, remained at 3.5%.

The unemployment rate was unchanged at 4.9%, slightly better than the 5.0% expected by economists. However, the number of people claiming unemployment-related benefits increased by 27,800 in August, considerably more than the forecast rise of 8,300. Claims had declined by 11,800 in the previous month.

The UK economy is therefore sending conflicting signals. Better than expected July growth data indicate that economic activity remains resilient, but weaker wage growth and the sharp increase in benefit claims point to a fragile labour market.

The Bank of England must balance the risk of persistent inflation against the possibility of further weakness in employment and economic growth. More expensive energy supports maintaining a restrictive policy stance, but stable services inflation and slowing wage growth reduce the need for an immediate rate increase.

Today’s inflation report is unlikely to materially change expectations ahead of tomorrow’s decision. The Bank of England is widely expected to keep interest rates unchanged. The market will focus primarily on the voting split and the guidance concerning future meetings.

At the end of June, markets were pricing in slightly more than one rate hike by the middle of next year. They now expect around four increases. This substantial shift reflects higher energy prices and the more hawkish stance adopted by major central banks. The European Central Bank has delivered a more restrictive message, the Reserve Bank of Australia is moving towards another increase, and the Federal Reserve and the Bank of Japan may also tighten policy.

Four Bank of England rate hikes still appear to be an aggressive scenario. Today’s inflation figures do not provide a clear justification for starting a rapid tightening cycle. Headline inflation has moved closer to 3%, but services inflation has not accelerated and wage pressures are gradually easing.

The forthcoming debate over the UK budget creates an additional source of uncertainty. Any renewed fiscal tightening could weaken economic activity and reduce the Bank of England’s room to raise interest rates.

GBP/USD initially rose to around 1.3495 following the CPI release before retreating towards 1.3480. The limited reaction suggests that the data have not fundamentally altered the outlook for UK monetary policy. If the Bank of England fails to validate the market’s hawkish expectations, investors may reduce their bets on future rate hikes, creating downside risk for sterling.

Since July 2025, GBP/USD has been trading within a broad consolidation range between 1.37–1.38 and 1.30–1.3160. The US dollar has been strengthening again since 26 August this year, although the scale of the decline in the currency pair remains limited for now. The long-term trend remains upward, with no clear signs of a reversal at this stage.