In December, UK inflation unexpectedly fell to 2.5%, a figure that has caught the attention of financial markets and potentially opened the door for interest rate cuts by the Bank of England (BoE) at its next meeting. This unexpected dip in inflation has resulted in a significant shift in market expectations, with the likelihood of a rate cut now at 74%, up from 62% before the figures were published. At one point, the probability surged to as high as 81%, as traders and economists absorbed the news.
The Consumer Prices Index (CPI), which tracks the average change in prices paid by consumers for goods and services, rose by 2.5% in the 12 months to December. This marked a slight decrease from November’s 2.6%, as reported by the Office for National Statistics (ONS). Economists had expected inflation to remain steady at 2.6%, so the lower-than-expected result has prompted speculation that the BoE may now feel comfortable cutting interest rates sooner than anticipated.
Several factors contributed to the decline in inflation, including easing price rises in key sectors such as restaurants, where price increases slowed, and hotels, where prices fell. These drops, coupled with a slowdown in inflation in other areas like tobacco, clothing, and footwear, helped to bring the overall inflation rate down. The combination of these factors has led many to speculate that the BoE may adjust its approach, especially considering that inflation had been a key driver in previous rate hikes. As the cost of living remains a concern for many, the move towards interest rate cuts could offer relief to borrowers, though it may also have wider implications for the UK economy.
As the February meeting approaches, all eyes will be on the Bank of England’s decision, with many wondering whether the latest inflation data will indeed prompt a shift in policy. A rate cut would mark a significant change in the Bank’s strategy, which had focused on raising rates in response to soaring inflation in previous months. If the BoE does move towards cuts, it would signal a shift in its efforts to stabilise the economy, especially if inflationary pressures continue to ease.
Ruth Gregory, the deputy chief UK economist at Capital Economics, commented on the unexpected drop in inflation, stating that “while a lot of the surprisingly large fall in services inflation from 5.0% in November to 4.4% in December was due to a very sharp fall in airfares, underlying price pressures still appear a bit more favourable than we had thought.” She added that this shift in inflation trends strengthens the case for a 25 basis point interest rate cut in February and lends some support to their view that rates could fall more quickly than markets expect.
The Bank of England (BoE) had already made two quarter-point rate cuts last year, lowering its key rate to 4.75%. However, with inflation easing somewhat, the possibility of additional rate cuts has become a more prominent discussion in financial circles. Gregory’s analysis suggests that the underlying economic conditions are more favourable than initially anticipated, which could further influence the BoE’s next steps.
Former Bank of England policymaker Michael Saunders also weighed in on the recent inflation figures, suggesting that they could pave the way for “slightly more interest rate cuts.” Speaking on BBC Radio 4’s Today programme, Saunders explained, “What we’ve seen in the last month or so is global interest rates rise very sharply, led by the US, and that’s rippled through to the UK.” He went on to mention that markets were already pricing in a couple of cuts before the inflation data was released, but with the latest figures aligning with the BoE’s expectations, this may influence the decision-making process moving forward.
This data has been seen as a positive development for the Bank of England, as it has a target of keeping inflation at 2% over the medium term, which is within the next two years. The alignment of current inflation trends with the BoE’s expectations signals that its monetary policy may be on track, offering a measure of relief to both the Bank and the wider economy. As such, the upcoming decision on interest rates will likely take into account this new data, with expectations now leaning towards the possibility of further cuts.
The Bank of England had initially forecast that inflation would hit 2.5% by the end of 2023, and with the latest figures aligning with this prediction, there is growing speculation that further interest rate cuts may be on the horizon. Michael Saunders, a former policymaker at the Bank, noted that if inflation were to remain at this level, markets could be “on the route to slightly more interest rate cuts,” as the economic conditions appear to be more favourable than anticipated.
Grant Fitzner, the chief economist at the Office for National Statistics (ONS), explained that inflation had eased very slightly in December, partly due to a dip in hotel prices. However, he also highlighted that the cost of tobacco played a role in the decline, as prices increased by less than they did at the same time the previous year. This downward pressure was offset somewhat by rising fuel costs and an uptick in the price of second-hand cars, which saw their first annual growth since July 2023.
One of the most closely watched indicators, services inflation, dropped from 5% in November to 4.4% in December, which was significantly lower than analysts had expected. Many had predicted a more modest decline to 4.8%, making this a more favourable outcome for the Bank of England.
Economist Adam Deasy from PwC noted that the fall in consumer price inflation came at a critical moment for both the Bank and the government. With UK growth slowing towards the end of the year, the news of cooling services inflation would be well received. He added that the recent sell-off in UK bonds had increased pressure on the government to take action, and any indication that inflation was still high would have only added to this pressure. He believes that this may provide the Bank of England with the green light it needs to resume its interest rate cuts.
Tomasz Wieladek, chief European economist at T Rowe Price, agreed with this assessment, stating that the data provided a “clear green light for another series of cuts.” However, not everyone shares this optimistic view. Matthew Ryan, head of market strategy at Ebury, suggested that the latest inflation figures would not lead to an immediate shift in the Bank of England’s strategy. He explained that while the “doves” on the Monetary Policy Committee may argue that weak activity data and a downward trend in inflation warrant immediate cuts, the “hawks” are likely to be more cautious. They will likely want more confidence that inflation is firmly on track to return to the 2% target, especially with uncertainties surrounding the new fiscal plans and potential tariff impacts.