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Bank of England interest rate decision on knife edge after inflation fall

<span>Photograph: Maja Smiejkowska/Reuters</span>
Photograph: Maja Smiejkowska/Reuters

The Bank of England is facing a knife-edge decision on interest rates after an unexpected fall in UK inflation last month, as financial markets bet the central bank could leave borrowing costs unchanged for the first time in almost two years.

In a crunch week for the economy, the August figures from the Office for National Statistics (ONS) on Wednesday saw financial markets revise their forecasts, raising the chance of the central bank keeping interest rates on hold on Thursday from 20% to more than 50%.

The UK’s annual inflation rate slowed to 6.7% last month amid weaker growth in food prices and monthly falls in the cost of hotels and air travel. Threadneedle Street, City economists and the chancellor, Jeremy Hunt, had anticipated a modest increase to 7% driven by rising petrol and diesel prices.

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The latest drop in the inflation reading from 6.8% in July marks the sixth straight decline in the headline rate. It does not, however, mean that prices are falling, only that they are rising at a slower pace.

Highlighting the pressure on households of the cost of living crisis, food and drink prices increased by 13.6% in the year to August, lower than their peak inflation rate of 19.1% earlier this year but still high by historical levels.

The expectation had been of a 15th consecutive rise in interest rates on Thursday, with a quarter-point increase to push inflation back towards the Bank’s 2% target.

However, with the central bank lending rate already at 5.25%, business leaders warned against pushing through a further increase as concerns mount over the strength of the economy. Private sector activity has cooled in recent months amid weaker levels of consumer spending and with companies facing higher borrowing costs. Figures from the jobs market also show a rise in unemployment and fewer vacancies.

“There are a number of red warning lights on the dashboard,” said Kitty Ussher, the chief economist at the Institute of Directors. “Previous rate rises are working to tackle inflation. And if the medicine is working, you need to give it time to avoid risking an overdose.”

The ONS said the largest impact on food and drink inflation was from milk, cheese and eggs, for which prices fell sharply between July and August, but they were still up by about 15% compared with a year ago. The cost of vegetables, as well as fresh, chilled and frozen fish and seafood, also fell on the month.

Core inflation – which excludes energy, food, alcohol and tobacco – fell by more than expected, from 6.9% in July to 6.2% in August, driven by lower services prices. Figures for core inflation and the service sector are watched closely by the Bank when determining interest rates.

Threadneedle Street had said last month it expected inflation to rise slightly in August before falling sharply to about 5% in October.

James Smith, an economist at the Dutch bank ING, said: “We’re still tempted to say the Bank of England will hike rates. But it’s a close call, and both wage and inflation data suggest the end of the current tightening cycle is very close to its conclusion.”

Hunt said the latest inflation figures showed the government’s plan was working. “But it is still too high, which is why it is all the more important to stick to our plan to halve it so we can ease the pressure on families and businesses. It is also the only path to sustainably higher growth,” the chancellor said.

Despite the latest fall in inflation, the UK remains an international outlier with the highest rate among G7 economies. It comes as the world’s leading central banks reach the end of the most aggressive tightening cycle in decades. Many economists anticipate borrowing costs will now be kept at elevated levels in an attempt to stop persistent inflationary pressures from becoming embedded.

Rachel Reeves, the shadow chancellor, said: “The prime minister is too weak to turn things around, while his predecessor, Liz Truss, continues to call for the same policies that crashed the economy this time last year.

“The Conservatives have wreaked havoc, and working people are paying the price.”