Staying steady at 3.8%, UK inflation surprised in September by coming in below both consensus and the Monetary Policy Committee’s (MPC) forecast of 4%. Behind the figure is weaker than expected food inflation, which helped to offset a big, but expected, rise in transport inflation. We anticipate inflation will stay around this level until early next year, when it will fall below 3%. In terms of the impact on the MPC’s decision making, we continue to expect that the next interest rate cut will come in February. However, if the Autumn Budget can avoid pushing inflation up, then we think the MPC might provide an early Christmas present in the form of a December rate cut.

What’s driving UK inflation right now?

Headline inflation remained at 3.8% for the third consecutive month. A big jump in airfares and motor fuel inflation was offset by weakness in multiple areas.

Starting with those transport components, base effects are the big story here. Volatile airfare inflation rose in September to 5.5% from -3.5%, despite prices falling 28.8% on the month. Similarly, fuel inflation rose to -1.2% from -4.9% as last year’s significant 3.9% drop in fuel prices pushed up the annual measure in September. These two components alone added 15bps to the latest headline inflation rate.

There were some downside surprises, too. Food inflation fell from 5.1% to 4.5%, which knocked 6bps from inflation. This will be reassuring for the MPC given food prices’ outsized role in influencing households’ inflation perceptions.

Services inflation held steady at 4.7%. Yet, if we look at this through the MPC’s measure of underlying services inflation – which excludes volatile and indexed components – then this dropped below 4% for the first time since February 2022.

UK inflation forecast: at peak and will remain elevated for the year

September’s data should be the summit of the recent rise in inflation. However, there won’t be a big drop in inflation just yet. Inflation will hover around 3.8% for the rest of the year before falling below 3.5% in January followed by a further dip in April, which will take inflation below 3%.

We see a few risks in both directions to this assessment. Starting with the upside risks, the first is that while inflation hasn’t hit that crucial 4% threshold where households and businesses start to pay much more attention to inflation, the recent – and continuing – period of elevated inflation and even higher food price inflation raise the risk that households bargain for bigger pay rises. Meanwhile, firms would then try to pass on rising input costs to consumers to protect margins. This scenario would increase the persistence of inflation.

Second, the labour market looks to be stabilising after April’s big hike in employment costs. Pay growth also continues to run well above the 3% level that’s consistent with 2% inflation. A recovery in the jobs market may mean there’s not enough slack to ensure pay growth returns to 3%. That said, private sector pay growth surprised to the downside in August, so we are growing more confident that this measure will continue to ease.

On the Autumn Budget, the risks point in both directions. The Chancellor will need to raise close to £30bn in taxes. With little offsetting increase in spending, this will suck demand out of the economy and help weigh on inflationary pressures.

The Chancellor also sounds determined to avoid another policy-induced inflation surge. On the spending side, it seems likely that the government will remove the 5% VAT on household energy bills from April. Indeed, were that policy implemented, then it would lower our inflation forecast by around 0.2ppts relative to where we had expected energy prices to go.

However, given the government’s commitment to not raise the big taxes, it will be hard to have an Autumn Budget that doesn’t push up inflation as the Chancellor looks to a smorgasbord of smaller stagflationary duties to raise revenue.

For now, we continue to expect inflation to come down quickly in the early part of next year.

What does the latest inflation data mean for interest rates?

While there’s reason to be cautious, we think the data has been decidedly dovish of late. Private sector pay growth excluding bonuses dropped by more than expected in August. Inflation also undershot the MPC’s forecast by 0.2ppts. This, fairly, will tempt some of the doves on the MPC to push for another rate cut this year.

All told, we think the MPC will want to stay on hold in November to be sure that inflation has peaked, as well as waiting to see what the Autumn Budget on 26 November holds. We continue to look to February as the next opportunity for a rate cut, but we do think the combination of easing food price inflation, a drop in oil prices and a potentially much less inflationary Autumn Budget than first thought could shift the balance towards a December rate cut.

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