UK inflation hits 3.5% as fuel costs surge, cementing Bank of England rate hike bets

UK inflation rose to 3.5% in the 12 months to September, up from 3.1% in August and 2.9% in July. Economists polled by Reuters had forecast 3.4%. The Office for National Statistics said the September reading was the highest annual inflation figure in almost a year, driven by motor fuel costs.

Motor fuel prices surged 29.8% in the year to September. The ONS said the motor fuel inflation rate hit its highest level since August 2022, when fuel costs jumped after Russia's full-scale invasion of Ukraine. Britain is a net energy importer, leaving it exposed to external energy shocks, including the U.S.-Iran war and the struggle to move oil through the Strait of Hormuz.

Markets price two Bank of England hikes

Markets are pricing in two rate hikes from the Bank of England by the end of the year. LSEG data showed a 98% chance that the Bank of England raises its key interest rate by 25 basis points to 4% next month. Most traders also priced a further hike of the same size at the central bank's final meeting of the year in December.

The market reaction was muted after the data release, with government bond yields little changed.

Scott Gardner, investment strategist at J.P. Morgan Personal Investing, said recent growth in headline inflation had "undone the progress we saw in the spring."

"Bank of England policymakers will be looking beyond the headline figure," he said. "Services inflation, in particular, has accelerated in recent months which will create concern that we are starting to see second round inflationary effects beyond energy prices. While we face a different set of challenges compared to 2021, the prolonged conflict is weighing on the U.K. economy and making the case for a rate hike stronger."

Budget pressure builds as debt tops £3 trillion

The inflation reading complicates the fiscal picture for the UK government and its finance minister. Chancellor of the Exchequer John Healey is due to unveil his first fiscal shakeup next week during the Autumn Budget. He is tasked with sticking to the previous government's fiscal rules, which aim to rein in public debt while delivering promises to soften the blow of surging consumer costs.

Separate data published on Wednesday showed UK national debt was estimated to have exceeded £3 trillion ($4 trillion) in September for the first time. The cost of servicing that debt has risen drastically over the past year, and the British economy is struggling to grow.

Healey said he would be "maintaining our fiscal discipline" in next week's budget, while working to "drive for growth [and give] businesses and families some breathing space."

Chancellor faces a high-wire act

Suren Thiru, chief economist at the Institute of Chartered Accountants in England and Wales, said rising inflation is turning the Autumn Budget into "a perilous high-wire act for the Chancellor." He said surging prices were "increasing pressure for cost-of-living support while pushing up government borrowing costs, which is shrinking fiscal headroom and narrowing his policy options."

"With inflation increasing, the pieces are falling firmly into place for a November rate rise," Thiru said. "Policymakers will also be looking to the Chancellor to avoid adding fuel to the inflation fire by delivering a credible, fiscally disciplined Budget."

The UK print matters for Nigerian businesses that trade with or source from Britain because sterling costs and UK interest rates feed into pricing and borrowing conditions. The immediate market reaction was muted.