UK inflation unexpectedly eases in December, which could reduce pressure in bond markets

LONDON (AP) — Inflation in the U.K. unexpectedly fell in December, a move that will likely fuel pressure on the Bank of England to cut interest rates again next month and give the U.K. government some breathing room following recent turbulence in financial markets.

The Office for National Statistics said Wednesday that inflation, as measured by the consumer prices index, was 2.5% in the year to December, largely as a result of easing price pressures in the services sector, which accounts for around 80% of the U.K. economy.

That was down from 2.6% the previous month. Economists had expected no change in the annual rate.

Though inflation has fallen, it remains above the Bank of England's target of 2%. The bank sets interest rates on what it expects inflation to be in the coming year or two, so if policymakers look past an anticipated uptick in coming months, they may decide to cut borrowing rates at the next policy meeting on Feb. 6 to the likely relief of Treasury chief Rachel Reeves, who has faced a stream of negative headlines in recent days over her handling of the economy since Labour returned to power last July for the first time in 14 years.

“The small tick down in inflation will be met with a big sigh of relief in both the Treasury and the Bank of England," said Luke Bartholomew, deputy chief economist at abrdn,

At the start of the year, financial markets had priced in the prospect of three to four quarter-point interest rate reductions this year from the current level of 4.75%. However, in recent weeks, concerns about the U.K.'s inflation outlook have tempered those expectations.

That's been evident in the bond market, where the interest rate investors charge the U.K. government to lend money over 10 years has hit a 16-year high amid concerns over the upcoming economic policies of U.S. President-elect Donald Trump as well as more domestic worries.

Whatever the reason, the bond market changes will likely lead to the government having to pay out more in interest rate payments, putting pressure on Reeves' projections for the public finances.

Critics have argued that her first budget last October will lead to higher inflation than otherwise would have been case. The extra public spending announced in the budget will be largely funded through increased business taxes and borrowing. Some economists think the splurge, coupled with the prospect of businesses cushioning the tax hikes by raising prices, could put upward pressure on inflation and lead to interest rates to be higher.

Inflation is way down from levels seen a couple of years ago, partly because central banks dramatically increased borrowing costs from near zero during the coronavirus pandemic when prices started to shoot up, first as a result of supply chain issues and then because of Russia’s full-scale invasion of Ukraine, which pushed up energy costs.

As inflation rates have fallen from multidecade highs, central banks have started cutting interest rates, though few, if any, economists think that rates will fall back to the super-low levels that persisted in the years after the global financial crisis of 2008-2009.