Inflation in the U.K. unexpectedly fell in December, according to official data on Wednesday that is likely to fuel pressure on the Bank of England (BoE) to cut interest rates again next month and give the government some breathing room following recent turbulence in financial markets.
The Office for National Statistics (ONS) said inflation, as measured by the consumer prices index (CPI), was 2.5% in the year to December, largely as a result of easing price pressures in the services sector, which accounts for around 80% of the U.K. economy.
That was down from 2.6% the previous month. Economists had expected no change in the annual rate.
Inflation is expected to rise again – many analysts forecast it will top 3% in early 2025 – and Treasury chief Rachel Reeves said there was "still work to be done."
Though inflation has fallen, it remains above the Bank of England's target of 2%. The bank sets interest rates on what it expects inflation to be in the coming year or two. So if policymakers look past an anticipated uptick in coming months, they may decide to cut borrowing rates at the next policy meeting on Feb. 6.
That would likely relieve Reeves, who has faced a stream of negative headlines in recent days over her handling of the economy since Labour returned to power last July for the first time in 14 years.
The BoE has said Britain's persistent inflation pressure means it will move only gradually with reducing borrowing costs despite signs that the economy is losing momentum.
The likelihood of slow rate cuts has contributed to a jump in borrowing costs that has threatened to knock Reeves off target for meeting her budget rules, possibly requiring her to cut public spending.
"The small tick down in inflation will be met with a big sigh of relief in both the Treasury and the Bank of England," said Luke Bartholomew, deputy chief economist at abrdn.
"For now, this slightly softer report should help reassure investors that the BoE can continue with its gradual easing cycle, and we expect the next rate cut in February," Bartholomew said.
At the start of the year, financial markets had priced in the prospect of three to four quarter-point interest rate reductions this year from the current level of 4.75%. However, in recent weeks, concerns about the U.K.'s inflation outlook have tempered those expectations.
That's been evident in the bond market, where the interest rate investors charge the U.K. government to lend money over 10 years has hit a 16-year high amid concerns over the upcoming economic policies of U.S. President-elect Donald Trump as well as more domestic worries.
Whatever the reason, the bond market changes will likely lead to the government having to pay out more in interest rate payments, putting pressure on Reeves' projections for the public finances.
Critics have argued that her first budget last October will lead to higher inflation than otherwise would have been the case. The extra public spending announced in the budget will be largely funded through increased business taxes and borrowing. Some economists think the splurge, coupled with the prospect of businesses cushioning the tax hikes by raising prices, could put upward pressure on inflation and lead to interest rates being higher.
The fall in the headline CPI rate reflected cheaper hotel rooms and clothes and a smaller rise in tobacco prices in 2023, the ONS said.
Underlying measures of price growth, which the BoE sees as a better guide to underlying price pressures, also slowed by more than expected.
Core inflation, which excludes energy, food, alcohol and tobacco prices, fell to 3.2% from 3.5% in November.
Services inflation stood at 4.4% in December – its lowest since March 2022 – compared with 5.0% a month earlier, the ONS said. Economists had forecast it would dip only to 4.9%.
"Are we on a linear path down for inflation? We don't think so," Sanjay Raja, Deutsche Bank's chief U.K. economist said, pointing to increases in April in the minimum wage and employers' social security contributions as well as higher energy and food costs.
"That said, the jump in price momentum will likely be temporary, with price inflation expected to normalize to more target-consistent levels next year."
Factory gate prices in December were 0.1% higher than a year earlier after November's 0.5% drop.
Inflation is way down from levels seen a couple of years ago, partly because central banks dramatically increased borrowing costs from near zero during the coronavirus pandemic when prices started to shoot up, first as a result of supply chain issues and then because of Russia’s full-scale invasion of Ukraine, which pushed up energy costs.
As inflation rates have fallen from multidecade highs, central banks have started cutting interest rates, though few, if any, economists think that rates will fall back to the super-low levels that persisted in the years after the global financial crisis of 2008-2009.