UK inflation fell unexpectedly in December to 2.5%, potentially opening the door to interest rate cuts by the Bank of England (BoE) next month.
Financial markets now assign a 74% probability to an interest rate cut at the Bank’s February meeting, up from 62% before the figures were published. The chances briefly surged to 81% as traders digested the news.
The Consumer Prices Index (CPI) rose by 2.5% in the 12 months to December, down from 2.6% in November, according to the Office for National Statistics (ONS). Economists had expected inflation to hold steady at 2.6%.
Easing price rises in restaurants and falling hotel prices last month helped the overall inflation rate come down, as did a slowing in tobacco, clothing, and footwear inflation.
Ruth Gregory, deputy chief UK economist at Capital Economics, said: “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.
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“That strengthens the case for a 25bps interest rate cut in February and lends some support to our view that rates will fall further and faster than markets expect.”
This data is welcome news for the Bank of England, which has a target of keeping inflation at 2% “over the medium term” — that is, within the next two years.
The BoE cut its key rate to 4.75% in two quarter-point moves last year.
Michael Saunders, a former Bank of England policymaker said the inflation figures may pave the way for “slightly more interest rate cuts”.
He told BBC Radio 4’s Today programme: “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.
“Markets are now pricing in only a couple of cuts, perhaps even slightly less than that. That’s where they were last night, before these figures. Now, these figures bring inflation back in line with what the Bank of England has been expecting.”
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The Bank had forecast that inflation would hit 2.5% by the end of 2023. Saunders said that if inflation were to remain at this level, markets would be “on the route to slightly more interest rate cuts.”
ONS chief economist Grant Fitzner 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.
