The Office for National Statistics has delivered a surprise to the City this morning. Headline CPI inflation held at 2.2% in August, defying the consensus forecast of a tick up to 2.4%. The pound sterling wobbled on the release, initially dipping before stabilising as traders digested the implications for monetary policy. Core inflation, stripping out volatile food and energy, eased to 3.1% from 3.3%, a clear signal that underlying price pressures are abating. Services inflation, the Bank of England's favourite gauge, also softened to 4.3% from 4.5%.
The real story for households, however, lies in the grocery aisles. Food price inflation slowed to 1.3% from 1.5%, its lowest since September 2021. Supermarket price wars, particularly among discounters Aldi and Lidl, are finally feeding through to the official data. This will be a welcome relief for families who have endured 20% rises in food costs over the past three years. Yet the relief is far from universal. Restaurant and hotel price inflation remains sticky at 4.6%, reflecting the hospitality sector's passthrough of minimum wage increases and business rates.
For the bond market, the inflation holdfast offers little clarity. Gilt yields initially fell on the softer services print but recovered as traders realised the Bank of England's August rate cut did little to stimulate demand. The 10-year yield is trading around 3.95%, still elevated by the fear that UK fiscal incontinence will keep inflation above target. Chancellor Rachel Reeves's Autumn Budget looms, and the market is betting on more borrowing. This is a dangerous game. History shows that when gilts lose their safe-haven status, capital flight follows.
The real crunch point? The housing market. The average two-year fixed mortgage rate remains above 5.5%. With inflation steady, the Bank of England is unlikely to cut rates again this year. The carry cost of servicing a mortgage at these levels means many homeowners are effectively cash-flow negative. This will eventually cap house prices, but for now, the market is in denial. The Royal Institution of Chartered Surveyors reports that new buyer enquiries have fallen for the third straight month.
In the currency markets, sterling's resilience is puzzling. The trade-weighted index is near its highest since 2016, but this is not a vote of confidence in the UK economy. It's a yield play. UK interest rates are higher than in the eurozone or Japan, attracting carry trade inflows. This is a double-edged sword. A strong pound helps curb import inflation but makes exports uncompetitive. The manufacturing PMI has been below 50 for months, signalling contraction.
Looking ahead, the data suggests the UK is trapped in a low-growth, high-debt equilibrium. The OBR's forecasts are consistently too optimistic; the public finances are deteriorating faster than expected. Corporate insolvencies are at a five-year high. The only thing keeping the economy afloat is consumer spending, but that is being fuelled by credit card debt and savings depletion.
My advice for investors? Stick to inflation-linked gilts and avoid UK domestic equities. The FTSE 100's heavy weighting in multinationals means it can weather a domestic storm, but the mid-cap index is a minefield. The market is betting that inflation will be tamed by a recession. That is a trade I would not make.
