UK inflation unexpectedly fell to 2.5 per cent in December, sparking increased expectations of an interest rate cut by the Bank of England next month.
The surprise decline from November’s 2.6 per cent marked the first drop in inflation for three months.
Markets have dramatically shifted their outlook following the data, with the likelihood of a February rate cut rising to 83 per cent.
Michael Saunders, a former member of the Bank of England’s monetary policy committee said: “If it stays like this, we will be on route to slightly more interest rate cuts.”
The drop in inflation was primarily driven by falling hotel prices and smaller-than-usual increases in airfare costs. Restaurant and hotel costs, while still rising, increased at their slowest pace since July 2021.
Ruth Gregory, deputy chief UK economist at Capital Economics, said the inflation figure “strengthens the case” for a base rate cut to 4.5 per cent next month.
The latest figures have provided some relief amid financial markets turmoil
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The latest figures have provided some relief amid financial markets turmoil, according to Suren Thiru, economics director at the Institute of Chartered Accountants in England and Wales.
He said: “While this surprise decline provides some timely respite amid the financial markets turmoil, with the headline rate still decisively above the Bank of England’s two per cent target and domestic and international inflation headwinds growing, any relief may be short-lived.”
The Bank of England decided to hold interest rates at 4.75 per cent last month after policymakers said the UK economy had performed worse than expected, with no growth at all between October and December.
Markets had previously priced in a 62 per cent chance of a rate cut to 4.5 per cent at the Bank of England’s February meeting. However, this probability has now jumped to 83 per cent, though markets still expect just two cuts throughout 2025.
Danni Hewson, head of financial analysis at AJ Bell said: “From just 60 per cent predicting a cut at the next meeting, expectations since the ONS figures were released have shot up to over 80 per cent.”
However, she cautioned: “It isn’t in the bag yet though – and the inflationary headwinds we have discussed previously (potential tariffs, an employer NI hike, and higher energy costs) haven’t gone away.”
Experts warn the decline in inflation may be temporary, with tougher conditions ahead.
Thiru added: “The near-term outlook for UK inflation remains ominous with higher energy bills likely to push the headline rate above three per cent over the coming months.”
Alice Haine, Personal Finance Analyst at Bestinvest, said: “While the better-than-expected figure opens the door for further interest rate cuts from the Bank of England, the drop in the headline rate is only expected to be temporary.”
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She explain there are more rises in inflation to come which is expected to be driven by April’s increase in Ofgem’s energy price cap.
However inflation could gradually decrease in the second half of 2025, if wage growth slows and the labour market weakens.
Chancellor Rachel Reeves responded to the December inflation reading, stating: “There is still work to be done to help families across the country with the cost of living.”
She highlighted Government actions including protection of workers’ payslips from higher taxes, frozen fuel duty and boosted national minimum wage.
Mortgage experts warn of continued uncertainty despite the positive inflation data.
Rachael Hunnisett, director at April Mortgages said: “The current uncertainty in both the mortgage and property markets is set to remain.”
Peter Stimson, Head of Product at MPowered Mortgages, cautioned that “things could get worse before they get better. The mortgage markets have now priced in just two cuts to the Base Rate in 2025, with at least one likely to be at the end of the year”.
Swap rates, which drive fixed-rate mortgage pricing, have been rising in recent weeks, with persistent inflation concerns remaining a key factor.