UK inflation preview: Downside surprise has higher chances and GBP/USD may struggle

• UK inflation figures have fallen short of expectations and are in a downtrend.
• Another miss would lower expectations for the BOE to raise rates.
• Brexit headlines remain central and will shape the data may have a limited impact on price action.

Relatively upbeat UK inflation has been supporting the pound – but that is changing. Economists expect the upcoming Consumer Price Index (CPI) figure to accelerate from 1.7% to 1.8% in September. That would take it closer to the Bank of England's 2% target. However, there are reasons to believe it may fall short of expectations once again.

In the past 12 months, CPI missed estimates six times and beat them only twice. Moreover, prices in the euro-zone – with which the UK still trades closely – dropped in September. 

Moreover, the broader picture is of a downtrend in annual price development after reaching a peak in late 2018. The following chart illustrates the downtrend. CPI has hit the lowest since mid-2017. 

GBP/USD potential reaction

First and foremost, it is essential to remember that Brexit headlines have the upper hand in moving GBP/USD. Every glimmer of hope for a deal sends sterling higher while talk of an imminent failure sends it lower. Economic figures – significant as they may be – tend to have a short-lived impact on the pound. 

However, when the direction of the surprise matches the current mood around the talks in Brussels, the impact may be more significant. 

The Bank of England has been expressing its desire to raise interest rates once Brexit uncertainty is removed. However, Michael Saunders, a hawkish member of the BOE, recently said that the bank might need to cut rates regardless of Brexit.

Miss: A failure of CPI to recover from the lows – even just by staying at 1.7% YoY – may be enough for an official change of stance. Therefore, the base case scenario is for 1.7% or less – which would weigh on the pound. The falls will be exacerbated if the publication comes at a time of pessimism about Brexit talks. The GBP/USD response will likely be muted if reports out of Brussels are optimistic. 

As expected: In the case of headline CPI meeting expectations with 1.8%, other figures such as Core CPI may come into play. However, the surprises in core prices are usually uncommon. Investors will likely ignore an "as expected" figure and move back to following Brexit headlines.

Beat: In case that CPI surprises to the upside – especially if it hits the BOE's 2% target – the pound has room to rise. Its rally may be more substantial if it comes on top of optimistic Brexit headlines. The upside move may be limited if the atmosphere in Brussels is gloomy.

Conclusion

UK inflation is significant for the pound as it impacts the BOE's rate decision. There is a higher chance for a downside surprise due to recent trends, and that may hurt the pound if Brexit headlines are gloomy at the time of the publication.