UK inflation fall boosts hopes of interest rate cut

The UK's inflation rate unexpectedly fell in December, fueling expectations of a potential interest rate cut next month. Data shows that prices rose by 2.5% in the year to December, down from 2.6% the previous month, marking the first drop in inflation in three months. This decline was mainly driven by lower hotel prices and smaller-than-usual increases in airfares, though the pace of price increases remains above the Bank of England's target.

Recent increases in UK borrowing costs have eased, and the pound has strengthened, relieving pressure on Chancellor Rachel Reeves, whose budget policies had previously been criticized for exacerbating market turmoil. Government borrowing costs had previously reached a 16-year high, and the pound had fallen to a 14-month low. Following the release of the inflation data, investors increased their bets on the possibility of an interest rate cut next month and anticipate further cuts before the end of the year.

The Bank of England decided to keep interest rates unchanged at 4.75% last month, after policymakers indicated that the UK economy was performing worse than expected, with no growth between October and December. Ruth Gregory, Deputy Chief UK Economist at Capital Economics, a UK economic research firm, stated that the inflation data "strengthened" the case for a rate cut to 4.5% in February. The inflation rate is significantly lower than its peak in October 2022, when prices soared, driving up household living costs and leading to interest rate hikes, which made loans, credit cards, and mortgages more expensive.

The Office for National Statistics (ONS) stated that a slowdown in restaurant price increases and a fall in hotel prices helped to drive down inflation. Price increases for tobacco products, including cigarettes, rolling tobacco, e-cigarette refills, and cigars, also slowed. However, Grant Fitzner, chief economist at the ONS, noted that increases in fuel and used car prices offset this effect. Following the release of the UK data, government borrowing costs fell back to levels seen last week, and the pound rose slightly to $1.22. Subsequently, US data showing a larger-than-expected drop in core inflation led to a further decline in UK borrowing costs, despite an increase in overall US inflation.

Chancellor Reeves stated that "more work still needs to be done to help families across the country with the cost of living," but she added that the government had "taken action to protect working people’s wages from higher taxes" and increased the minimum wage. However, Shadow Chancellor Mel Stride said that economic growth had been "choked off by this government" and called on Reeves to "urgently explain how she will achieve it". In response to market turmoil, it is understood that Reeves will bring forward the publication of Labour's industrial strategy. Jan Sidenham, investment director at Rathbones Investment Management, said on the BBC's Today program that investors need to "see some detail on the UK’s plan". She said: "Are there going to be some tax breaks for certain sectors? I think the market wants to see specifics and actions."

Rising borrowing costs have a knock-on effect on the government's tax and spending plans, as it will have to pay more interest to finance its existing debt. This will reduce the amount of money available for public services and investment. Chief Secretary to the Treasury Darren Jones said on the BBC that public service departments "have to live within their means." When asked if this meant spending cuts were on the way, he replied: "It's just about prioritizing." Jonny Gettings, operations director at Ennio's, a Southampton Italian restaurant and small hotel, told the BBC that the business's outlook had "definitely deteriorated" due to increases in the minimum wage and National Insurance contributions, as well as a reduction in business rate relief from April.

Gettings added that reducing staff hours would be a "last resort," but the restaurant may consider shrinking the menu, reviewing suppliers, or changing opening hours. "Once you put your prices up, you're facing another raft of problems in terms of customers voting with their feet and going somewhere else to eat," he added. "You can only charge so much for a dish on the menu, otherwise, the customer will say, 'hang on a minute, hold on.'" Some people have mobile phone and broadband contracts linked to inflation, meaning their bills will rise in April in line with the latest data. Comparison site Uswitch said these bills are expected to rise by an average of £21.99 a year for broadband and an average of £15.90 a year for mobile. However, due to new regulations, many contracts now show any expected increases in pounds and pence each year during the agreement.

Separate data released by the ONS on Wednesday showed that average rental costs rose by 9% in December compared to the same period last year, and UK house prices increased by 3.3% in the 12 months to November, with Northern Ireland seeing the biggest increase.