According to the Office for National Statistics, consumer prices rose by 2.5% year-on-year, a decrease from the 2.6% increase recorded in November. This figure aligns with the Bank of England's November forecast and surpasses the stagnant reading anticipated by private-sector economists.
There are indications that underlying inflationary pressures are easing, as price growth in the services sector fell to 4.4%, the lowest level since March 2022, down from 5%. However, this decline was primarily influenced by a significant drop in volatile airfares and a notable reduction in hotel price inflation, with economists cautioning that these trends could reverse.
Nonetheless, the more substantial-than-expected decrease in price pressures reassured investors following a week of financial market instability that had driven benchmark government bond yields to a 17-year high, jeopardizing Chancellor of the Exchequer Rachel Reeves’ economic strategy. Rising borrowing costs have put her at risk of violating her fiscal rules ahead of a critical update from the Office for Budget Responsibility on March 26.
On Wednesday morning, the 10-year gilt yield fell by eight basis points to approximately 4.8%, a more significant decline than observed in European bonds, providing Reeves with some additional leeway. The pound initially dropped by as much as 0.4% after the inflation data was released but later rebounded to $1.224, showing a slight increase for the day.
In her response to the inflation figures, Reeves did not address the recent market downturn but acknowledged that there is “still work to be done” to manage inflation effectively.
Following the inflation report, traders adjusted their rate cut expectations, incorporating an additional 12 basis points of easing by year-end. This adjustment suggests that they now largely foresee two quarter-point cuts in 2025. Governor Andrew Bailey and other rate-setting officials have indicated their support for further reductions at a “gradual” pace.
Energy Expenses
Economists have cautioned that inflation may rise again this year, potentially exceeding 3%, influenced in part by increasing energy and fuel prices. This projection surpasses the Bank of England's earlier expectation of a 2.8% peak noted in November. Ven Ram, a cross-asset strategist at Bloomberg, indicated that any reduction in inflation might only provide temporary relief for gilts, as traders remain apprehensive that significant cost pressures are still forthcoming.
Fluctuating factors may have contributed to the notable decline in services inflation, alleviating some investor concerns. This decrease was significantly impacted by a 26% year-on-year drop in airfares, a notoriously unstable element. Additionally, the typical rise in airfares during the December holiday season was the smallest observed in five years.
Ruth Gregory, Deputy Chief UK Economist at Capital Economics, highlighted that half of the 0.6 percentage point decrease in services inflation was attributable to airfares, which are subject to volatility. She noted, “While the softening is not as pronounced as it may initially seem, the underlying price pressures appear somewhat more favorable than previously anticipated.”
There remains a concern that Reeves is overseeing an economy vulnerable to stagflation, characterized by high prices coupled with sluggish growth. Projections for Thursday suggest that the economy expanded by only 0.2% in November, indicating that Britain may be heading toward a second consecutive quarter of stagnation.
These figures represent the last assessment of prices before the Bank of England's decision on February 6 regarding the possibility of reducing interest rates for only the third time since the cuts began in August.
Traders are now looking forward to critical inflation data expected later on Wednesday in the US, where bonds have also faced pressure, seeking insights into the Federal Reserve's timeline for interest rate reductions.
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| UK’s Unexpected Inflation Slowdown Provides Respite for Reeves · Bloomberg |
"Inflation has slightly decreased this month due to a drop in hotel prices, although it remains higher than a year ago. Additionally, the cost of tobacco contributed to this decline, as its price increase was less pronounced compared to the same period last year," stated Grant Fitzner, Chief Economist at the ONS.
Core Consumer Price Index (CPI) inflation, which excludes energy, food, alcohol, and tobacco, decreased to 3.2% from 3.5%, falling short of economists' predictions.
Cost pressures in the pipeline remain low, with producer fuel and raw material prices down 1.5% compared to the previous year, and the cost of goods exiting factories rising only 0.1%.