UK core inflation drops by more than expected

UK inflation as measured by the consumer price index (CPI) eased back in December to 3%, from 3.1% in November. The core inflation figure, which strips out more volatile items such as fuel and food dropped more than expected in December to 2.5%, after registering 2.7% in November. A drop to 2.6% had been pencilled in. This is the first time that inflation has softened since June.

Room to breathe at the BoE

This surprise drop in core inflation has caught the eye of the market and will bring some relief to Mark Carney & Co. at the Bank of England. The central bank’s inflation report has pointed towards inflation peaking in 2017, for it to start easing back in 2018, which is precisely what we are seeing. Whilst one month by no means constitutes a trend, the BoE governor will not be writing a letter to the Chancellor, explaining the high levels of inflation, as he had to last month. The BoE is by no means out of the woods, but at least the monetary policy members are unlikely to feel backed into a corner, any rate hike decisions will be firmly pushed back after the 0.2% drop in core inflation.

Consumer still likely to feel squeezed

The ticking down of inflation levels will technically mean that pressure should be easing on the squeezed UK consumer, who has had to struggle against rising prices and falling wages in real terms since the pound dropped over 1000 points, after the Brexit referendum, in 2016. However, the reality is that such a small drop in unlikely to be registered by the consumer and felt in their wallet.

Average wage rises are just 2.3% compared to 3% inflation, down from 3.1%, this is just too small a drop for the consumer to notice the difference in their day to day spending. In this regard the consumer will continue to feel squeezed and investors will now be turning their attention to retail sales figures which are due for release on Friday, looking for answers to the question as to whether the UK consumer still spending despite the big squeeze on household purses? UK retail sales are forecast to have increased to 2.6% in December, up from 1.5% in November.

Market reaction:

Following the release, the immediate reaction has unsurprisingly been a selloff in the pound. Sterling lost ground as investors reassessed the prospects of any monetary policy tightening in the near futures. GBP/USD dropped 0.2% to $1.3760 and is likely to continue falling back from its recent post Brexit high. However, continued weakness in the dollar could keep losses capped. Versus the euro, a slight pull back in the pound has also be noticeable, however given the weaker German wholesale inflation reading, again losses are being limited.

The slightly weaker pound has given the FTSE a boost, picking it up off the flatline and boosting it to 7787, an increase of 0.2% on the day. Support can be seen at 7767 and then again at 7750.