Outlook Turns Uncertain As Inflation Rebounds

The Pound Sterling traded choppily against both the euro and the US dollar on Wednesday as hotter-than-expected UK inflation complicated expectations for the Bank of England’s next rate cut and kept markets on edge after a volatile week of data.

Sterling traders have been whipsawed by a run of conflicting UK data this week.

Tuesday’s weaker wage growth revived expectations of a Bank of England rate cut as early as March, but those odds eased again on Wednesday after inflation unexpectedly ticked higher.

The mixed signals leave the outlook uncertain and could keep volatility elevated in the pound.

Volatility has been high across global markets this week following the escalation in tensions over Greenland, and sterling has been no exception. On Tuesday, slower wage growth and signs of a cooling labour market sent the pound lower and increased the probability of a March rate cut from the Bank of England. That move was partially reversed on Wednesday after hotter-than-expected CPI data suggested the BoE may need to tread more carefully when easing policy again.

CPI Ticks Up Again

UK inflation was widely thought to have peaked at 3.8% last year, with several subsequent prints pointing lower as labour market tightness and wage pressures eased. Headline CPI fell to 3.2% in November, and another drop had been expected for December.

Instead, data from the Office for National Statistics showed inflation rose back to 3.4%, catching markets off guard. Consensus forecasts had pointed to a reading closer to 3.1%, and the upside surprise disrupts the recent narrative of a smooth glide back towards the Bank of England’s 2% target.

The main drivers behind the stronger reading were a combination of higher tobacco duties and persistent strength in services prices. Recent tax increases on tobacco products added to headline pressure, but it was services inflation that will concern policymakers most. Services CPI remains elevated, reflecting ongoing pass-through from wages into prices across areas such as hospitality and travel, suggesting domestic inflation pressures remain sticky.

Gilt yields rose after the release as traders scaled back expectations for near-term easing. Markets had been leaning towards a spring rate cut, especially after Tuesday’s jobs report showed further moderation in wage growth. That optimism has now been tempered, with expectations shifting towards later in the year.

There is no clear consensus on the policy outlook. Some analysts, including ING, argue the inflation uptick will prove temporary and that easing remains on track.

“The latest rise in UK inflation from 3.2% to 3.4% in December shouldn’t last. We expect headline CPI to reach 2% and even temporarily dip below in April. That should unlock further rate cuts in March and June, earlier than markets expect.”

This divergence of views highlights the uncertainty facing sterling. The pound found some support after the CPI release, firming against both the euro and the US dollar as interest rate differentials briefly moved in its favour. However, gains were limited by concerns that keeping rates higher for longer risks further weighing on already fragile UK growth.

Looking ahead, the latest data leaves Governor Andrew Bailey facing a difficult balancing act ahead of the next policy meeting in early February. Inflation at 3.4% widens the gap between the UK and its international peers, particularly the United States and the eurozone, where price pressures have eased more consistently. That divergence raises the risk of the UK being viewed as a high-inflation, low-growth outlier if progress on disinflation stalls.