UK Inflation at 3.5% with Interest Rates at 3.75%—Examining the Resumption of Rate Hikes and the Spillover to Long-Term Government Bonds
The tug-of-war between “prices and interest rates” is intensifying once again in the UK. The Consumer Price Index (CPI) for September 2026 rose 3.5% from the same month last year, accelerating from 3.1% in August. While the policy interest rate remains on hold at 3.75%, three out of nine members at the Bank of England (BOE) September meeting supported a hike to 4.00%. With the policy announcement on November 5 approaching, additional rate hikes have become a realistic point of contention. UK Office for National Statistics (ONS) September CPI / BOE September Meeting Minutes
The difficulty here is that the Bank of England cannot directly stop the rise in crude oil and gas prices. Raising interest rates can be expected to curb demand and prevent spillover into wage and price setting. On the other hand, in a phase where real income is already being squeezed by high energy costs, it further burdens mortgages and corporate financing. Moreover, the yield on 30-year government bonds reflects not only the next policy rate but also future inflation and the supply-demand balance of fiscal and government bonds.
In this article, we will categorize the resurgence of UK prices into “temporary import price shocks” and “domestically entrenched price increases,” and examine the conditions under which policy rates and long-term government bond yields move separately. For Japanese investors who do not directly hold UK government bonds, this also serves as material for considering the yen exchange rate, global long-term interest rates, and bond investments.
1. The content of 3.5% inflation—cannot be explained by fuel prices alone
The September CPI released by the ONS on October 21 was 3.5% year-on-year. This is a 0.4 percentage point increase from 3.1% in August. It rose 0.4% month-on-month, and the fact that the month-on-month change in the same month last year was almost flat also pushed up the year-on-year figure. Transportation, especially automotive fuel, contributed most significantly to the acceleration of the year-on-year growth rate, while restaurants and hotels contributed in the opposite direction. ONS “Consumer price inflation, UK: September 2026”
Meanwhile, core CPI, which excludes energy, food, alcohol, and tobacco, also rose from 2.6% in August to 2.8% in September. The services CPI has risen from 3.4% to 3.7%. Therefore, it cannot be definitively stated that “only the headline CPI rose because of crude oil.” However, it is also premature to conclude that the chain of wages and service prices has become entrenched based solely on one month’s rise in core indicators.
There are CPI and CPIH in UK price indicators. The September CPIH was 3.6%, and because it includes owner-occupier housing costs, its scope differs from the 3.5% CPI. Since the BOE’s monetary policy target is 2% for CPI, it is necessary not to mix different indicators and calculate “how many points left until 2%.”
2. The 6-to-3 vote to hold at 3.75%—the point of contention is the speed of policy, not prices
In the monetary policy decision announced on September 17, the BOE kept the Bank Rate on hold at 3.75%. Against the 6 in favor, three members—Megan Greene, Catherine Mann, and Huw Pill—supported a hike to 4.00%. They place heavy weight on the energy supply shock associated with the Middle East situation and the possibility of secondary effects occurring in the process of inflation returning to 2%. BOE “September 2026 Monetary Policy Summary and Minutes”
The surge in energy prices is a supply shock related to production capacity and transportation. Even if interest rates are raised, the supply of crude oil will not increase. Nevertheless, the central bank considers a response because there is a risk that companies will continuously pass on cost increases to sales prices, workers will demand wage hikes commensurate with high prices, and expected inflation rates themselves will remain high. Conversely, if high energy prices weaken consumption and narrow the room for price hikes, the necessity to rush into rate hikes will diminish.
The UK economy is not in a state of complete stall here. According to the ONS, real GDP for the three months to August 2026 increased by 0.7% compared to the previous three months. On the other hand, the increase for the single month of August was limited to 0.1%. As for wages, regular pay for June-August was up 3.7% from the same period last year, and growth after inflation adjustment was 0.6% on a CPIH basis. Although there is a certain resilience in the economy and wages, it is not a situation where one can judge from a single indicator that there is sufficient room for rate hikes. ONS “GDP monthly estimate, August 2026” / ONS “Average weekly earnings, October 2026”
Note that simply subtracting the September CPI of 3.5% from the policy rate of 3.75% results in 0.25 percentage points. However, this is not a precise real interest rate that shows the actual degree of monetary tightening. This is because what should be combined with the nominal interest rate is the “expected inflation rate” with a matching duration, which differs from the past 12 months of CPI performance.
3. 30-year government bond yields move according to a more complex equation than policy rates
When considering long-term yields on UK government bonds (gilts), one cannot simply compare the 3.75% policy rate with the 30-year bond yield to judge whether they are expensive or cheap. Long-term yields can be broadly thought of as being divided into the average expectation of future short-term interest rates and the premium added for the risk of holding long-term bonds (term premium). Furthermore, nominal yields also incorporate future outlooks for prices and real interest rates.
For example, even if the BOE raises rates by 0.25 percentage points tomorrow, if the market thinks that this will curb inflation in a few years and that future policy rates will be lower than previously expected, the 30-year bond yield may fall. Conversely, even if the policy rate is kept on hold, if inflation drags on and investors demand significant risk compensation for long-term bonds, the 30-year bond yield could rise.
In the UK, the “buyers” of government bonds cannot be ignored. While there is demand to match the ultra-long-term liabilities of pension funds and insurance companies, new government bond supply due to fiscal deficits and the reduction of bonds held by the BOE affect market supply and demand. Therefore, the explanation that “30-year bonds are being sold because the UK central bank is hawkish” confuses the short term with the long term.
4. The magnitude of a 0.5 percentage point rise in interest rates on bond prices
It is easier to understand if we replace this with numbers. The price change of a fixed-rate bond can be roughly expressed as “negative modified duration × yield change width.” If you hold a long-term bond with a modified duration of 15 years, if the yield rises by 0.5 percentage points, the price will fall by approximately 7.5%. Conversely, if it falls by 0.5 percentage points, the price is calculated to rise by approximately 7.5%.
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Modified duration 15 years, yield +0.25 percentage points: approx. 3.75% price decline
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Same, yield +0.50 percentage points: approx. 7.5% price decline
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Same: -0.50 point yield change: approximately 7.5% price increase
This is merely a hypothetical example for explanation and does not represent the actual duration of all UK 30-year government bonds. Actual values vary depending on the coupon, remaining maturity, and yield level. Significant interest rate changes also introduce errors due to convexity. Depending on whether the factor moving yields by 0.5 points is a “rate hike” or “fiscal distrust,” the subsequent impact on the economy, stocks, and foreign exchange will differ.
For example, if the price of a long-term bond portfolio worth 1 million pounds falls by 7.5%, the unrealized loss would be approximately 75,000 pounds. Even if holding bonds to maturity allows for redemption at face value, if there is a need for interim sales or collateral posting, the decline in market value can turn into a real liquidity problem. This point is essential when considering the turmoil surrounding UK LDI (Liability-Driven Investment) in 2022.
5. UK Exit Policy—The Government Is Not the Only Seller of Government Bonds
At the September meeting, the BOE unanimously supported a multi-year plan to gradually phase out the approximately 368 billion pound balance of government bonds held for monetary policy purposes by the end of 2034. The average annual pace of reduction is about 46 billion pounds, with a policy of combining 20 billion pounds in annual sales with reductions through redemptions. Operational details are to be finalized, and specific practical matters such as auction management have not yet been fixed.BOE September Meeting Minutes
What is easily confused here is “government bond issuance” versus “central bank reduction of bond holdings.” The former is supply to raise fiscal funds, while the latter is Quantitative Tightening (QT) to reduce bonds held through past Quantitative Easing (QE). From an investor’s perspective, both can increase the amount of bonds the market must absorb, but there are differences in the buyer base, timing, and maturity composition. The impact on market prices is not determined by the total face value alone.
What makes the UK different from 2008 is not just the strengthening of bank capital regulations. The 2022 gilt crash showed that even safe assets like government bonds can see market functionality shaken when holders’ leverage and collateral posting needs chain together in a short period. This time, even if rate hike expectations and government bond supply overlap, it does not necessarily mean the same turmoil will occur. However, it is necessary to monitor the speed of long-term interest rate increases and market liquidity simultaneously.
6. Three Scenarios That Will Determine the Decision on November 5
A: Hold and maintain vigilance. A case where the BOE judges that while it is wary of the secondary effects of high energy prices, there is still insufficient evidence that wages and service prices will continue to accelerate. Even if the policy rate remains at 3.75%, if inflation forecasts are revised upward, the bond market may perceive it as hawkish. Conversely, if concerns about the economy intensify, long-term yields could fall.
B: Rate hike to 4.00%. A case where the BOE places greater emphasis on the stickiness of service prices and wages, upside risks to expected inflation, and economic resilience. Short-term rates will rise, but if long-term bonds are perceived as a “restoration of credibility to curb inflation,” the rise could be smaller, or there may even be room for yields to fall. After the announcement, the future guidance on additional rate hikes and economic forecasts will be more important than the presence or absence of a rate hike.
C: High inflation and economic slowdown occurring simultaneously. A case where high energy prices hurt household real income and consumption slows, while inflation remains above target. Both rate hikes and rate cuts are difficult. If fiscal risks and term premiums also rise, long-term interest rates will climb even if the short-term policy rate is held steady, which would be the most troublesome development for the market.
The November 5 meeting is scheduled to have its policy decision and Monetary Policy Report released at noon UK time. This article is based on materials as of November 4, and does not treat the results of the November meeting as known.BOE “MPC dates”
7. Five Indicators to Watch in the Next News
① Headline, Core, and Services CPI. If only headline CPI moves due to fuel effects, and core or services slow down, the possibility of a temporary shock increases. If all three strengthen together, concerns about persistence will grow. However, do not jump to conclusions based on one month of fluctuations.
② Year-on-year regular wages and real wages. Observe whether wages continue to follow prices. Even if nominal wages are high, if it is due to productivity improvements or temporary wage increases, it does not directly link to persistent inflation. I also want to check the breakdown between the private and public sectors.
③ MPC vote split and inflation forecasts. Whether support for rate hikes increases from 6 to 3, or how the hold camp changes their forecasts, will indicate the center of gravity for policy. It is necessary not to directly equate a single dissenting vote with the probability of a rate hike at the next meeting.
④ Yield spread between 2-year and 30-year bonds. If 2-year yields rise and 30-year yields fall, there may be an interpretation that “short-term tightening will curb future inflation.” If only 30-year yields rise significantly, suspect term premiums or fiscal/supply-demand concerns. However, changes in expected growth rates are also mixed in.
⑤ Pace of QT implementation and government bond auction absorption. Observe who is absorbing the central bank’s reduction in holdings and the government’s supply. If auction bid-to-cover ratios, yield premiums at bidding, or market bid-ask spreads deteriorate, market functionality risks separate from inflation will surface.
The movement of UK government bonds is not irrelevant to Japanese investors. If the rise in long-term interest rates originating in the UK spills over to major government bonds, it could affect the yields required by investors in Japanese or US government bonds. However, the pound-yen rate is not determined solely by UK interest rates; it is influenced by BOJ policy, global risk aversion, and yen supply and demand, so it is dangerous to predict a stronger pound simply based on rising UK interest rates.
8. The Perspective for Reading UK Government Bonds Requires More Than Just “Will They Raise Rates?”
The UK stands between the need to raise interest rates to address high prices and the necessity of supporting households and businesses suffering from high energy costs. Neither the 3.75% policy rate nor the 3.5% CPI figure alone can determine the appropriateness of monetary policy. It is necessary to read them in conjunction with which prices are rising, how long that will last, and how much it is spreading to demand and wages.
Regarding long-term government bonds, it is not a binary choice where they are sold if a rate hike is decided or bought if rates are held steady. Future policy rates, inflation expectations, government and central bank bond supply, and the risk appetite of buyers interact with each other. At the next policy announcement, looking not only at the decided interest rate but also at how short-term and ultra-long-term bonds reacted differently will make it easier to grasp what is actually being feared in the UK market.
Which do you weigh more heavily in the UK’s next interest rate decision: ‘service prices’ or ‘supply and demand for long-term government bonds’? At Financial Koala, we explain the mechanisms of interest rates, foreign exchange, and financial markets every day. Please follow us to read our future analyses.
Next time, following the BOE policy decision on November 5, we will compare the announcement details with the reactions of UK 2-year and 30-year bonds. We plan to verify what the market has priced in rather than just the presence or absence of a rate hike.