December’s unexpected drop in UK inflation to 2.5% has ignited speculation of potential interest rate cuts by the Bank of England (BoE) as early as next month. Financial markets are now pricing in a significant probability of a rate reduction at the February meeting, reflecting growing anticipation of a more dovish monetary policy stance.
The Consumer Prices Index (CPI) rose by 2.5% in the year to December, down from 2.6% in November, defying economist expectations of a steady rate. This decline was primarily driven by easing price pressures in restaurants and hotels, coupled with slower inflation in tobacco, clothing, and footwear. This positive development provides the BoE with greater flexibility in managing monetary policy amidst a backdrop of slowing economic growth.
Ruth Gregory, Deputy Chief UK Economist at Capital Economics, noted that while a significant portion of the decline in services inflation can be attributed to falling airfares, underlying price pressures appear more favorable than anticipated. This reinforces the argument for a 25 basis point interest rate cut in February and supports the view that rates may fall further and faster than current market expectations. The BoE’s inflation target of 2% over the medium term appears increasingly achievable with this recent data.
The BoE implemented two quarter-point rate cuts in 2023, bringing the key rate to 4.75%. Former BoE policymaker Michael Saunders suggests the latest inflation figures could pave the way for further cuts, particularly in light of recent global interest rate increases. He emphasized that the December inflation reading aligns with the BoE’s forecasts, potentially prompting a reassessment of the current market pricing for future rate cuts.
ONS Chief Economist Grant Fitzner highlighted the contributing factors to the inflation decline, including lower hotel prices and slower tobacco price increases, partially offset by rising fuel and second-hand car costs. The notable drop in services inflation to 4.4% in December, significantly below analyst forecasts, further strengthens the case for a potential shift in monetary policy.
Adam Deasy, Economist at PwC, welcomed the timely decline in inflation, considering the slowing UK growth momentum. He suggests that the cooling services inflation alleviates pressure on the government to take action and potentially provides the Monetary Policy Committee with the necessary justification to resume rate cuts. This sentiment is echoed by Tomasz Wieladek, Chief European Economist at T Rowe Price, who views the data as a “clear green light” for further cuts.
However, Matthew Ryan, Head of Market Strategy at Ebury, cautions that the data may not significantly alter the BoE’s trajectory. He anticipates ongoing debate within the BoE, with “doves” advocating for immediate rate cuts based on weak activity data and easing inflation, while “hawks” may prefer more evidence of sustained disinflation before committing to further easing. Uncertainties surrounding new fiscal plans and trade policies could also influence the BoE’s decision-making process.
In conclusion, the unexpected fall in UK inflation has heightened expectations of interest rate cuts by the Bank of England. While the data presents a compelling case for easing monetary policy, the central bank will likely carefully consider various factors, including economic growth prospects and prevailing uncertainties, before making a final decision. The February meeting will be crucial in determining the BoE’s next steps and their impact on the UK economy.
