Brewing Inflation to Underpin Pound Sterling's Rally Against Euro and Dollar

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The British pound trades near multi-month highs against the dollar and euro as traders see risks of a renewed inflationary impulse.

The British Retail Consortium (BRC) reports Tuesday that "rising inflation defies expectations" after shop price inflation increased to 1.5% year on year in January, up from 0.7% in December and above the 3-month average of 0.9%.

"Any suggestion that inflation has peaked is simply not borne out by these figures," says Helen Dickinson, Chief Executive of the BRC.

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The BRC's findings are the latest in a string of surveys indicating the Bank of England can't be complacent in its battle to bring inflation back down to 2.0% on a sustained basis.

The surveys warn official inflation prints risk surprising to the upside again in coming months, which will limit the Bank's opportunity to lower interest rates further.

This is fundamentally supportive of the pound which has steadily risen during the past two weeks as the UK's forward-looking interest rate profile lifts: the pound to euro exchange rate is back above 1.15 and the pound to dollar reached a new four-month high at 1.3713 on Monday.

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Gains are more likely to hold if interest rate expectations continue to lift, but this will rely heavily on what inflation does.

The BRC says food inflation increased to 3.9% year on year in January, against growth of 3.3% in December.

This is a significant finding as economists are pinning expectations for a sharp fall in the UK's headline inflation rate partly on the assumption that food prices will fall noticeably in the coming months. They think the UK's food price inflation will mimic the fall in food prices seen in Europe.

The UK could be denied a European style fall in prices owing to the UK government's policy changes: "It is a challenging time for households. Retailers do what they can to keep prices down in a competitive market, but thin margins and rising costs of Government policy make it harder," says Dickinson.

Above: Expectations for the future of UK interest rates shows investors are increasingly of the view the Bank of England will raise rates more aggressively in future months.

However, the BRC's findings are just the latest in a string of surveys indicating that economists can't be complacent and that inflationary pressures could stay elevated.

January's PMI survey released last Friday showed inflationary pressures facing private sector firms was noticeable: strong input cost inflation persisted and resulted in the greatest increase in average prices charged by private sector firms since August 2025.

"With prices looking stickier on forward-looking data... the risk now is for a slowdown in the pace of rate cuts - including a possible Q1-26 skip," says Deutsche Bank's Raja.

The pound fell steadily against the euro during 2025 as markets saw scope for the Bank of England to cut further than most peer central banks in 2026.

However, this was based on the view inflation and unemployment were to fall further. These survey figures warn that assumptions on inflation might be misplaced.

"Government must double down on costs in order to support households. A good place to look is the spiralling energy charges, especially non‑commodity levies, which are raising operating costs, squeezing margins and flowing through into retail prices," says Dickinson.