UK inflation rose ahead of the Bank of England's interest rate decision, narrowing the window for a no-step policy.

UK inflation rose further ahead of the central bank's interest rate decision, with energy price shocks continuing to impact household bills and consumption, squeezing the Bank of England's room to remain on hold.

On September 16, data released by the UK Office for National Statistics showed that the Consumer Price Index (CPI) rose 3.1% year-on-year in August, higher than July's 2.9%, reaching its highest level since March this year, in line with market expectations. Rising petrol and diesel prices were the main driver, and higher household energy bills further pushed up overall inflation.

The Bank of England will hold its Monetary Policy Committee (MPC) meeting on Thursday. The market widely expects the central bank to keep the benchmark interest rate unchanged at 3.75%, but if the energy shock continues to push up inflation, the market has begun betting that the central bank may raise rates again as early as November. After the inflation data was released, traders' pricing for a rate hike this week actually fell from 35% to 25%, indicating that the market still believes the central bank is likely to remain on the sidelines in the short term.

At the same time, rising inflation has increased the government's fiscal pressure. The sharp rise in UK government bond yields has already been estimated to have reduced the government's fiscal space by more than half, further compressing the policy maneuvering space in the October budget.

Energy prices are the main driver of rising inflation.

August's accelerated inflation was primarily driven by energy prices. The UK Office for National Statistics indicated that a sharp rise in petrol and diesel prices was the primary factor contributing to the CPI increase that month, while increases in airfares and factory gate prices also played a role, and higher household energy bills provided further support.

In early July, the UK energy regulator Ofgem raised the cap on household energy prices by 13%, directly pushing up electricity and gas prices. Meanwhile, Brent crude oil recently broke through $100 a barrel again, and Ofgem has announced plans to raise the energy price cap again in October, meaning that energy prices may continue to support inflation in the coming months.

David Rees, global head of economics at Schroders, said that UK inflation could rise further in the coming months as energy, industrial goods and food prices continue to be passed on to end consumers.

According to The Wall Street Journal, the market currently expects the UK CPI to reach or exceed 4% early next year, double the Bank of England's 2% target.

Core inflation remains stable, giving the central bank room to wait and see for the time being.

However, the overall rise in inflation does not mean that price pressures have spread across the board. Core inflation, excluding energy and food, remained at 2.6% in August, while inflation in the services sector, which is closely monitored by the Bank of England, also remained stable at 3.4%.

This means that the current upward pressure on inflation remains primarily concentrated in external factors such as energy, and has not yet clearly evolved into broader domestic price pressures. ING strategist Francesco Pesole stated that there is currently "no evidence that inflationary pressures are spreading beyond energy," which also supports the dovish stance within central banks.

The cooling labor market has also given the central bank some room to pause its actions. Official data released Tuesday showed that private sector wage growth (excluding bonuses) was 2.8% in the three months to July, down from 2.9% in the previous period; overall weekly earnings also rose by only 2.9% year-on-year.

David Rees points out that current wage trends have not yet replicated the wage-price spiral of 2022. In other words, as long as the energy shock does not further accelerate wage and service price increases, central banks still have reason to continue observing rather than immediately responding to energy prices by raising interest rates.

The central bank's wait-and-see strategy is facing increasing challenges.

The problem is that the duration and scope of the energy shock are becoming increasingly important. The Bank of England has kept interest rates unchanged since the outbreak of the Middle East conflict in February, awaiting more evidence on whether inflation is sustainable; while the MPC's 6-3 vote to keep interest rates unchanged at its last meeting in July also shows that there are already significant divisions within the policymaking body.

KPMG Chief Economist Yael Selfin said rising energy prices could test the Bank of England's "wait-and-see strategy." She believes the current price increases do not appear to be driven by an overheated economy or a second-round effect, but if inflation persists, the central bank may implement a precautionary rate hike in November; until then, energy price shocks remain an external factor difficult for the central bank to directly control.

Andrew Goodwin, a UK economist at Oxford Economics, also said that while the August data has not yet shown a second-round effect, the rise in external price pressures is already so significant that the MPC is increasingly likely to be forced to take action.

Inflationary and interest rate pressures are further impacting the fiscal front. High government bond yields are eroding government fiscal space, while rising living costs are increasing the political pressure on the government to alleviate the burden on households. Chancellor of the Exchequer John Healey stated that the Middle East conflict is driving up inflation globally, and the government has taken preemptive measures to help households and businesses; Shadow Chancellor Andrew Griffith, however, criticized the situation, saying that 3.1% inflation means households are facing higher living costs.

Therefore, the Bank of England will most likely remain on hold on Thursday. However, as energy prices continue to transmit to inflation data, the room for further inflation increases is shrinking. Going forward, whether core inflation, service prices, and wage growth can remain stable will be key to determining whether the central bank can maintain its wait-and-see stance.

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