UK inflation fell unexpectedly in December, dipping to 2.5% from 2.6% in November. This decrease raises the possibility of interest rate cuts by the Bank of England (BoE) in its upcoming February meeting.
Financial markets are now pricing in a 74% likelihood of a rate cut, a significant rise from 62% before the inflation data was released. At one point, the probability surged to 81% as traders absorbed the news.
Key Factors Behind Inflation Drop
The Consumer Prices Index (CPI) showed a 2.5% rise in the 12 months leading up to December, contrary to expectations that inflation would remain at 2.6%. A decrease in restaurant prices, falling hotel rates, and a slowdown in inflation for tobacco, clothing, and footwear contributed to the overall drop.
Ruth Gregory, Deputy Chief UK Economist at Capital Economics, pointed out that the unexpected fall in services inflation, particularly airfares, played a significant role. She noted that while underlying price pressures appear more favorable, this strengthens the case for a 25 basis points rate cut in February.
BoE’s Inflation Target and Rate Cut Expectations
The Bank of England aims to keep inflation at 2% over the medium term, within the next two years. In response to rising inflation, the BoE lowered its key interest rate to 4.75% in two quarter-point moves last year.
Michael Saunders, former BoE policymaker, suggested that the latest inflation figures could pave the way for additional rate cuts. He explained that global interest rates, particularly in the US, have risen sharply, impacting the UK. If inflation remains at this level, it could lead to further rate reductions.
Factors Driving the Inflation Slowdown
ONS Chief Economist Grant Fitzner attributed the inflation slowdown to falling hotel prices and lower tobacco costs. However, rising fuel prices and the first annual increase in second-hand car prices since July 2023 partially offset the overall decline.
Services inflation, a closely monitored sector, decreased from 5% in November to 4.4% in December, surpassing analyst expectations. Adam Deasy, Economist at PwC, highlighted that this drop comes at a crucial time, especially as UK economic growth slowed towards the end of 2023. He added that the cooling of services inflation will be welcomed by both the BoE and the government.
Market Reactions and Predictions
The news of lower inflation provided relief to UK bonds, which had suffered in the recent market sell-off. Tomasz Wieladek, Chief European Economist at T Rowe Price, described the data as a “clear green light” for another series of rate cuts.
However, Matthew Ryan, Head of Market Strategy at Ebury, believes that the data may not significantly alter the BoE’s approach. He argued that while the doves (those advocating for rate cuts) may point to weak economic activity and the downtrend in inflation, the hawks (those favoring higher rates) will likely want more confidence that inflation is on track to meet the 2% target, especially with uncertainties around new fiscal plans and potential tariffs under the Trump administration.
Overall, the latest inflation figures have sparked mixed reactions, but they provide a favorable outlook for those anticipating further rate cuts by the Bank of England.
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