LONDON — In a surprising turn of events, the inflation rate in the United Kingdom experienced a decline in December, which has raised optimism regarding potential interest rate cuts by the Bank of England in the upcoming month. This development comes as a relief to the U.K. government amid recent financial market instabilities.
On Wednesday, the Office for National Statistics released data indicating that the inflation rate, as defined by the consumer prices index, stood at 2.5% for the year ending in December. This decrease is primarily attributed to a reduction in price pressures within the services sector, which constitutes roughly 80% of the U.K. economy. This latest figure represents a slight drop from the previous month’s inflation rate of 2.6%, which many analysts had anticipated would remain unchanged.
Despite the decline, current inflation levels are still above the Bank of England’s established target of 2%. However, the central bank bases its interest rate decisions on projected inflation over the next year or two. Should policymakers overlook a potential increase in inflation in the coming months, they may choose to lower borrowing rates at their next meeting scheduled for February 6.
Following the release of this inflation data, financial markets are increasingly considering the likelihood of an interest rate cut next month. This news may provide some comfort to Treasury chief Rachel Reeves, who has faced significant scrutiny regarding her management of the economy since Labour regained power last July after a 14-year hiatus.
In reaction to the inflation figures, the yield on the U.K. government’s key 10-year bond decreased noticeably. Luke Bartholomew, deputy chief economist at abrdn, commented, “The slight decline in inflation will bring considerable relief to both the Treasury and the Bank of England.”
At the beginning of the year, financial markets expected to see three to four quarter-point interest rate reductions from the current rate of 4.75%. However, concerns regarding the outlook for inflation in the U.K. have started to temper those anticipations.
This sentiment is reflected in the bond market, where the interest rates on loans to the U.K. government over a ten-year period reached a 16-year high of 4.93%. This increase is fueled by worries over the economic policies of U.S. President-elect Donald Trump, alongside mounting domestic concerns. Following the inflation report, the interest rate on the benchmark 10-year bond saw a decrease of 0.08 percentage points, settling at 4.81%.
Looking ahead, if the upward trend persists, the government may face increased interest payment obligations, potentially complicating Reeves’ financial commitments and projections related to public finances.
Critics have pointed out that Reeves’ inaugural budget last October could lead to higher inflation levels than might otherwise have been the case. This budget, which proposed additional public spending, is largely expected to be financed by raising business taxes and increased borrowing. Some economists are concerned that this spending spree, in combination with businesses possibly offsetting tax hikes by increasing prices, could exert further upward pressure on inflation, ultimately resulting in higher interest rates.
Inflation levels have significantly decreased compared to figures recorded a couple of years prior, largely due to central banks dramatically raising borrowing costs from near-zero rates during the coronavirus pandemic. These inflationary pressures arose first from global supply chain disruptions and subsequently from the rise in energy prices following Russia’s full-scale invasion of Ukraine.
As inflation rates have subsided from their multi-decade peaks, central banks have begun to lower interest rates. Nevertheless, it is widely believed among economists that rates are unlikely to return to the extremely low levels witnessed in the aftermath of the global financial crisis of 2008-2009.
