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.
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.”
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%.
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.”
Closely watched services inflation fell from 5% in November to 4.4% in December, which was well below analyst expectations for a decline to 4.8%.
Adam Deasy, economist at PwC, said:”The fall in consumer price inflation could not come at a better time for both the Bank of England and Number 10. With UK growth momentum slowing further at the end of the year, the news that services inflation has finally cooled will be welcomed.
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“UK bonds suffered in the recent market sell off, so any indication that inflation was continuing to run hot would have put pressure on the government to take action.
“Some pressures remain, particularly in light of the autumn budget, but this may be the green light the monetary policy committee needs to resume the rate cutting cycle.”
Tomasz Wieladek, chief European economist at T Rowe Price, said the data was a “clear green light for another series of cuts”.
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However, Matthew Ryan, head of market strategy at Ebury believes the latest inflation figures will do little to change the BoE’s path.
He said: “We don’t think that the data will change things too much for the Bank of England. One the one side, the doves will argue that weak activity data and signs of a downtrend in inflation warrant immediate interest rate cuts.
“Yet, the hawks will argue that they need more confidence that inflation is returning to target, particularly given uncertainties surrounding the new fiscal plans and Trump’s tariffs.”
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