UK inflation holds at 2.2% but services prices keep BoE on alert

By Suban Abdulla

LONDON (Reuters) -British inflation held steady in August but sped up in the services sector which is closely watched by the Bank of England, data showed on Wednesday, adding to bets that the central bank will keep interest rates on hold on Thursday.

Consumer price inflation of 2.2% last month was unchanged from July, the Office for National Statistics said, matching the median forecast in a Reuters poll of economists although it was below the BoE's latest projection of 2.4%.

Services inflation - an indicator of domestic price pressures - rose to 5.6% from 5.2% in July. The Reuters poll had pointed to a smaller rise to 5.5%.

One factor behind the rise was a 22.2% jump in air fares between July and August. Fares usually rise between the two months but the statistics office said the jump was the second largest since records began in 2001.

Sterling strengthened against the dollar after the data was published and investors trimmed their bets on the BoE cutting rates on Thursday to a roughly 26% chance from more than one in three on Wednesday.

Rate futures suggest investors still expect two quarter-point rate cuts by the end of 2024.

The BoE cut borrowing costs from a 16-year high of 5.25% to 5.0% in August but has signalled it will move carefully on further reductions as wage growth - a big driver of inflation in the services sector - is slowing only gradually.

Despite the acceleration of services prices overall, economists said the trend in the sector - excluding volatile items such as air fares - continued to weaken.

"The underlying story is slowly improving and we think that means faster rate cuts through the winter, even if we're expecting no change at tomorrow's meeting," James Smith, UK developed markets economist at ING, said.

But Luke Bartholomew, deputy chief economist at abrdn, said BoE policymakers will likely focus on the various measures of underlying inflation that remain elevated.

Core inflation, which excludes more volatile energy, food and tobacco prices, sped up on a monthly and yearly basis.

"That helps explains why the Bank of England is likely to be somewhat more cautious than the US Federal Reserve in its easing cycle over the next few months," Bartholomew said.

The U.S. central bank is widely expected to cut interest rates later on Wednesday, possibly by as much as half a percentage point.

Data last week showed inflation at 2.5% in the U.S. and 2.2% in the euro zone, both the slowest increases since 2021.

British Prime Minister Keir Starmer's Labour government, which is trying to speed up economic growth, said the data showed inflation was more manageable - it hit a four-decade high of over 11% nearly two years ago - but prices remained high.

Separate data showed manufacturers' costs for raw materials and energy fell by 1.2% in annual terms in August, a bigger drop than expected by the economists polled by Reuters. Factory selling prices rose by the least since January.

(Reporting by Suban Abdulla, editing by William Schomberg and Christina Fincher)