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UK inflation unexpectedly fell in December, handing some breathing space to the chancellor, Rachel Reeves, after a week of turbulence in financial markets.
With the government under pressure on the economy, figures from the Office for National Statistics showed the consumer prices index eased to 2.5%, below a reading of 2.6% in November, meaning prices rose at a slower rate.
City economists had forecast inflation would remain unchanged on the previous month. However, inflation remained above the Bank of England’s 2% target, while experts warned it could rise above 3% before the end of this year.
Grant Fitzner, the ONS chief economist, said: “Inflation eased very slightly as hotel prices dipped this month, but rose a year ago. The cost of tobacco was another downward driver, as prices increased by less than this time last year.
“This was partly offset by the cost of fuel and also secondhand cars, which saw their first annual growth since July 2023.”
In a crunch economic update just as the government battled to reassure jittery bond market investors, the latest snapshot could open the door for the Bank to cut interest rates as early as next month. UK interest rates stand at 4.75%, after cuts in August and November last year.
“[The latest figures] strengthens the case for a 25 basis point interest rate cut in February and lends some support to our view that rates will fall further and faster than markets expect,” said Ruth Gregory, the deputy chief UK economist at the consultancy Capital Economics.
The pound gained 0.1% against the dollar, rising to $1.2228 on Wednesday morning as financial markets priced the probability of an interest cut next month at 73%, up from 62% before the inflation figures were released.
The yield – effectively the interest rate – on 30-year UK government bonds, or gilts, has fallen by nearly 5 basis points to 5.399% – after soaring to 5.472% on Monday, the highest since 1998. Reeves has faced sustained pressure over the cost of borrowing in recent days.
In response to the December inflation figures, the chancellor said: “There is still work to be done to help families across the country with the cost of living. That’s why the government has taken action to protect working people’s payslips from higher taxes, frozen fuel duty and boosted the national minimum wage.
“In our plan for change, we were clear that growth is our number one priority to put more money in the pockets of working people. I will fight every day to deliver that growth and improve living standards in every part of the UK.”
The latest snapshot showed core inflation – which excludes volatile items such as energy, food, alcohol and tobacco – rose at a slower rate than expected in December, cooling from 3.5% in November to 3.2%. Services inflation, which is closely watched by the Bank of England, also fell, from 5% to 4.4%.
Threadneedle Street had signalled it would take a gradual approach to cutting borrowing costs after inflation fell from a peak of more than 11% in late 2022, when soaring energy prices fuelled a surge in the cost of living.
However, analysts have warned that sticky inflation could derail cuts from the central bank despite stalling economic growth. Investors also warn that Reeves could be forced to U-turn on a pledge not to increase taxes should higher borrowing costs threaten to break her fiscal rules.
The chancellor has come under intense pressure in the past week amid a rise in government borrowing costs to the highest level in decades. Driven by a global sell-off in bond markets, investors warn the UK is particularly exposed with a mix of weak growth, sticky inflation, and elevated government borrowing.
Reeves on Tuesday signalled she was prepared to make emergency spending cuts to balance the books if required, while arguing her priority was to go “further and faster” to boost economic growth in an effort to placate financial markets.
Despite last month’s drop in inflation, economists warned it could rise again in coming months, fuelled by rising energy bills. The Ofgem consumer price cap increased by 1.2% in January, and is expected to creep higher from April.
Business leaders have also said Reeves’s planned £25bn increase in employers’ national insurance contributions and 6.7% rise in the minimum wage from April could add to inflationary pressures.
Scott Gardner, an investment strategist at Nutmeg, said: “This data will increase the chances that the Bank of England cuts interest rates in February, though the path remains murky for multiple interest rate cuts this year.”
