In a surprising turn of events, UK inflation unexpectedly picked up for the first time in 10 months, causing traders to revise their expectations for rate cuts from the Bank of England this year. According to the Office for National Statistics, the Consumer Prices Index rose to 4% in December from a year earlier, exceeding economists' expectations of a slight fall to 3.8%. Services inflation also increased, while a core measure excluding food and energy remained at 5.1%.
This unexpected rise in inflation has dampened optimism stemming from recent reports indicating a slowdown in price pressures. The UK economy stagnated in the latter half of 2023, teetering on the edge of a recession, and wage growth has slowed, signaling a cooling labor market. Bank of England Governor Andrew Bailey has consistently emphasized a higher-for-longer stance on interest rates, cautioning that the January CPI figures could show an increase due to higher household energy bills.
As a result of this inflation surprise, bond prices fell, and the pound strengthened as traders adjusted their expectations for monetary policy easing in the coming months. Previously, there were predictions of four quarter-point reductions, with a 50% probability of a fifth cut. However, as recently as last month, six reductions were considered inevitable. The yield on two-year gilts climbed by as much as 15 basis points to 4.32%, while the pound traded 0.2% stronger against the dollar at $1.2667.
Alpesh Paleja, lead economist at the Confederation of British Industry, commented, "Today's inflation figures show it isn't 'job done.' Risks to the inflation outlook remain very much on the upside." He also mentioned that Ofgem's decision to lift the energy price cap in January could lead to a minor increase in the CPI rate.
The acceleration of services inflation, which Bank of England officials closely monitor for signs of underlying price pressures, reached 6.4% in December from 6.3% in November. It seems that spending during the Christmas season contributed to this inflationary trend. The prices of clothing, computer game consoles, sports equipment, toys, and DVDs jumped, particularly in the recreation and culture category. These figures indicate that retailers were not compelled to heavily discount goods to stimulate demand during the festive period, possibly hinting at stronger December retail sales data, to be released on Friday. However, the British Retail Consortium expressed concerns about facing higher costs and noted that progress in reducing prices would be threatened.
While food inflation continued to slow, dropping to 8% in December from 9.2% in November, the increase in alcohol and tobacco prices offset this decline. Alcohol and tobacco prices rose by 12.8% compared to a year ago, largely due to tax hikes on tobacco announced in the Autumn Statement.
Nevertheless, inflation remains well below the Bank of England's November forecasts, which allows the government to claim credit for fulfilling its promise to cut price increases in half last year. The Chancellor of the Exchequer, Jeremy Hunt, emphasized the need to continue with their efforts to control borrowing and boost growth with competitive tax levels.
Forecasters predict that inflation could reach the Bank of England's 2% target by April, driven by a significant drop in household energy bills. This projection is much earlier than the Bank of England's previous estimate that inflation would only return to target by the end of 2025. Yael Selfin, chief economist at KPMG UK, believes that the overall improvement in inflation outlook combined with a slowdown in the domestic economy will likely prompt the Bank of England to begin cutting interest rates from the second half of the year.
These latest inflation figures follow a series of reports indicating a moderation in inflationary pressures. The contraction of the UK economy was more significant than anticipated in both the second quarter and October-November, edging the country closer to a recession. Additionally, job vacancies are declining, and wage growth is slower than expected, further alleviating upward pressure on prices. As a result, traders have started to bet on the first rate cut possibly occurring as early as May, followed by four additional quarter-point reductions by year-end.
While inflation may pose a bumpy road in the coming months, Roger Barker, Director of Policy at the Institute of Directors, asserts that "inflation in the economy is still broadly moving in the right direction." Furthermore, pipeline inflation pressures are easing, as both producer input and output prices fell faster than anticipated in December. The cost of fuel and raw materials was 2.8% lower than the previous year, primarily due to declines in the price of chemicals and crude oil. However, services producer prices rose slightly in the fourth quarter, indicating persistent inflation pressures.