The latest UK inflation data has once again put the spotlight on the Bank of England’s policy path and the pound’s near-term trajectory. With consumer prices rising faster than expected, investors are weighing whether sticky inflation could delay interest rate cuts and keep sterling supported in the short run. But beneath the surface, the picture for the UK economy remains mixed, with a heavy reliance on government activity masking private sector weakness.

Inflation Still Running Hot

July’s consumer price index figures came in stronger than forecast, with both headline and core inflation rising 3.8% year-on-year. While a seasonal jump in airfares explained much of the surprise, the broader trend shows inflationary pressures remain persistent. Services inflation climbed back to 5%, while core inflation is now at the highest level among the G10 economies.

The Bank of England had already signalled that price pressures could linger, revising its September CPI forecast up to 4% from 3.7%. This foresight helped dampen the market reaction, with sterling only briefly pushing higher before running into resistance. Market expectations for interest rate cuts were only slightly trimmed, suggesting investors are not yet convinced this surprise changes the bigger picture.

Monetary Policy Stuck Between Inflation and Growth

The challenge for policymakers is balancing stubborn inflation against an economy that is far from booming. While recent GDP and labour market data look stable on the surface, much of this resilience is coming from the government rather than the private sector. Public sector hiring offset job losses in the private economy earlier this year, and Q2 growth was similarly propped up by government spending.

This dynamic makes the Bank of England’s task more complicated. Keeping rates higher for longer could suppress demand further in the private sector, widening the gap between state-led and market-driven growth. But cutting too soon risks reigniting inflation, particularly in services, where pricing remains elevated.

Sterling’s Outlook: A Tale of Two Pairs

In currency markets, the pound’s outlook is likely to diverge depending on the counterpart. Against the dollar, US data and Federal Reserve policy are expected to dominate, meaning UK inflation will play only a secondary role. By contrast, the euro-pound cross may be more directly swayed by domestic economic performance and the Bank of England’s policy path.

HSBC economists currently expect UK rates to fall to around 3% by the third quarter of 2026. If that trajectory materialises, sterling could weaken against the euro over the medium term, especially as the European Central Bank may not need to ease as aggressively.

Political and Fiscal Risks Ahead

Beyond inflation and monetary policy, government choices are set to play a major role in shaping the pound’s direction. Fiscal policy has already cushioned the economy this year, but the upcoming Autumn Budget could either reinforce that support or tighten conditions. Given how reliant UK growth has been on public sector activity, any fiscal shift could have an outsized impact on investor sentiment and sterling.

Bottom Line

The pound may find near-term support from sticky inflation and a cautious Bank of England, but the underlying health of the UK economy tells a more fragile story. With growth increasingly reliant on government spending and future rate cuts expected, sterling’s longer-term outlook looks more challenging—particularly against the euro. The next few months will hinge not only on inflation data but also on fiscal policy decisions that could tip the balance for both the economy and the currency.