Why a small drop in inflation matters to you

2025-01-16 05:30:00

Abstract: UK inflation slightly decreased, easing pressure. Underlying inflation fell significantly, signaling potential rate cuts. Uncertainty remains due to Trump's tariffs and upcoming NICs increases.

Typically, a slight decrease in the inflation rate doesn't make a significant impact. For example, a drop from 2.6% to 2.5% has minimal effect on the macroeconomy or the pressure on household living costs. This particular decline was primarily attributed to falling hotel prices and a smaller-than-usual increase in airfare prices in December.

However, this 0.1% drop is unusually significant because it signals a reprieve and provides some breathing room for Chancellor Rachel Reeves. This is mainly due to the supporting factors behind it, namely the underlying inflation data.

The Bank of England closely monitors underlying inflation data, which reflects year-long price pressures, when considering interest rate cuts. Core inflation, which excludes the direct impact of energy and food price volatility, has fallen to a four-year low, dropping from 3.5% to 3.2% in December. Service sector inflation also fell sharply from 5% to 4.4%, its lowest level in two years. This is genuinely positive news.

For those who delve deeper, supply chain inflation, including in the service sector, also indicates an easing of inflationary pressures. Therefore, the inflation situation in the UK can be viewed from different angles. While no one can accurately predict how the Bank of England will react, this removes an obstacle to a rate cut next month. Markets adjusted this morning and are now anticipating further rate cuts beyond February this year.

However, two major uncertainties remain: one is whether President-elect Trump will impose massive tariffs as he has threatened; and the other is how UK businesses will respond to the upcoming increase in National Insurance Contributions (NICs) and the rise in the minimum wage in April. Additionally, energy prices are also expected to rise in April, which will affect bills.

The tariffs, as well as the upcoming NICs and minimum wage adjustments, may not cause as severe problems for the UK economy as some have warned. While some expect businesses to raise prices due to budget adjustments, some companies may also choose to compress wages through lower-than-expected annual pay increases. The overall inflationary impact depends on how businesses react, which is currently unclear.

Similarly, Trump's tariffs could cause inflation in the US, thus affecting US interest rates. However, some at the Bank of England believe that cheaper tariffed goods imported from China may be diverted to the UK, which would help control inflation in the UK. How things will actually play out remains uncertain, but the outcome could be contrary to expectations.

Therefore, the slight decrease in UK inflation can be seen as a temporary "firebreak," temporarily calming the excessive panic that has emerged in the past few weeks. Those who have been shorting the UK on international markets will see that there is another side to this gamble. The UK's inflation level is in the middle of the G7.

Nevertheless, the so-called global "bond market tantrum" still exists, which is highly sensitive to each new data point. The UK government still needs to be convincing on the details of its growth plan. This means accelerating the implementation of infrastructure, industrial, and trade strategies. Market borrowing rates remain high, and the Chancellor may need to adjust spending plans with new spending cuts before Easter to meet her own borrowing rules.

Donald Trump's unconventional trade policies cast a shadow over the inflation outlook and all markets. Volatility has not disappeared. Inflation is likely to rise again in the coming months. But for now, both the UK's headline and underlying inflation rates are pointing in the right direction. It is a welcome temporary safe harbor, but the seas are still choppy.