Unexpected drop in inflation lifts pressure off Rachel Reeves

Rachel Reeves has been handed breathing space after better-than-expected inflation figures raised expectations for a Bank of England rate cut and reduced UK borrowing costs.

After a tough week for the government on the economy, official figures showed inflation unexpectedly cooled in December to 2.5%, down from 2.6% in the previous month, meaning prices rose at a slower rate.

Lifting some of the pressure on the chancellor as she sought to talk up Labour’s growth agenda, the latest snapshot sent the yield – in effect the interest rate – on UK government bonds tumbling at the fastest rate since 2023.

With 10-year gilt yields falling by almost 0.2 percentage points to about 4.7%, the sharp decline erased nearly all of the increase of the past seven days, when turmoil in the bond market had forced Reeves to contemplate spending cuts to meet her fiscal rules.

On a day of relief in global markets – after US figures showed cooling underlying inflationary pressures in the world’s largest economy – economists said the latest UK snapshot had raised the chances of the Bank of England cutting official interest rates when its policymakers next meet on 6 February.

With the economy on the brink of stagnation, a senior Bank policymaker warned on Wednesday that interest rates could need to be drastically reduced to avoid inflicting lasting damage on households and businesses.

In a speech in Leeds, Alan Taylor, who joined the Bank’s rate-setting panel last year, said a “more accelerated pace of rate cuts” than currently expected by the City could be needed to shore up the economy.

Suggesting that rates may need to be dropped to as low as 3.25% this year, from a current level of 4.75%, he said: “My view is that we’ve made it to the last half mile on inflation, but with the economy weakening, it’s time to get interest rates back toward normal to sustain a soft landing.”

Official figures are expected to show the economy returned to growth in November after shrinking in October. The Bank has forecast that growth over the entire second half of 2024 is on track to have stagnated.

The prospect of deeper interest rate cuts is likely to ease the pressure on the government after a rocky start to the year, after Labour’s critics had called for Reeves to resign amid accusations that her autumn budget was damaging the economy.

In fierce exchanges in the Commons during prime ministers’ questions, Keir Starmer was forced to defend his chancellor, saying she would remain in the post for “many, many years to come” as he sought to dampen talk of an emergency budget.

It emerged last week that Reeves was considering imposing steeper cuts to public services to repair the government’s finances after a bruising week in markets, while investors questioned whether the chancellor would be forced to raise taxes.

Pressing the prime minister to rule out tax increases, Kemi Badenoch, the Conservative leader, warned Labour’s policies would add to inflationary pressures as companies would be forced by tax increases in the autumn budget to pass on the costs to consumers in the form of higher prices.

However, the government sought to get back on the front foot with a flurry of announcements heralding overseas investments in Britain, including a £4bn project to build 6,500 homes, three schools and an arena on brownfield land in Bristol.

Aiming to restate Labour’s commitment to growing the economy as the primary means of repairing the government finances and fixing battered public services, the chancellor said she would “continue to go further and faster” to kickstart the economy.

Despite cooling in December, economists said inflation would still probably increase in coming months, fuelled by rising energy bills. The energy regulator Ofgem’s consumer price cap increased by 1.2% in January, and is forecast 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 stoke inflationary pressures.

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 rise in the cost of living.

However, analysts have warned that sticky inflation could derail cuts from the central bank despite stalling economic growth.