How serious is the UK’s inflation setback?

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December’s unexpected rise in UK inflation is a setback for those who had hoped the Bank of England was already entering the home straight of its long journey to restore price stability.

The figures, showing consumer price inflation rose to 4 per cent from 3.9 per cent in November, have knocked market expectations for the timing of the BoE’s first interest rate cut. By early afternoon, investors saw an even chance, rather than a near certainty, of a reduction from 5.25 per cent to 5 per cent in May.

Victoria Clarke, UK chief economist at Santander CIB, said the data was “a wake-up call for investors who have been considering the BoE home and dry on getting inflation sustainably back to target”.

But economists said the figures did not change the overall picture: that price growth had already slowed further than the BoE expected in November and could be below the central bank’s 2 per cent target by the spring — provided geopolitical tensions do not throw things off course.

Lalitha Try, economist at the Resolution Foundation think-tank, said the quickening of inflation last month — mirroring similarly unwelcome increases in the US and eurozone — “serves as a reminder that bumps in the lower inflation road are inevitable but does not change the big picture”.

One reason not to worry too much about the setback is that some of the main contributors to the rise were one-offs — such as the increase in tobacco excise duty — or goods and services whose prices are often volatile and hard to adjust for holiday seasonality.

Air fares rose by almost 60 per cent on the month; clothing prices increased in a month when retailers often discount heavily; live music, package holidays and theatre tickets also climbed steeply.

The National Institute of Economic and Social Research think-tank said its in-house measure of underlying inflation, which excludes the prices that have swung most sharply in a given month, showed UK inflation had slowed to 5.5 per cent in December from 5.7 per cent the previous month. 

Despite these pressures, Britain is rapidly becoming less of an international outlier on price rises — after two years in which its economic problems have persistently looked worse than those of its peers.

With US inflation at 3.4 per cent in December — also a slight increase on the previous month — the transatlantic gap in price pressures has narrowed to its slimmest since July 2022. Similarly, headline inflation in the eurozone has picked up to 2.9 per cent, marking the smallest difference in a year.

The UK could undershoot its peers within months, as the recent drop in wholesale gas prices — more important in Britain than elsewhere — feeds through with a time lag to regulated household bills.

Economists polled before the latest data release by Consensus Economics, a consultancy that aggregates forecasts, expected UK inflation to drop below 2 per cent by the spring, while inflation in the US and eurozone would still be running above that level.

“In a few months’ time, the UK will have shaken off its tag as the global inflation laggard,” said Paul Dales, economist at the consultancy Capital Economics.

When the BoE’s Monetary Policy Committee updates its economic forecasts at its meeting early next month, it is likely to take a more optimistic view than it did in November on the outlook for growth and inflation, largely as a result of the lower gas price that will underpin its projections. 

Nonetheless, rate-setters are likely to view the latest data as vindication of the cautious approach they have taken until now, underlining that they will need to see clear evidence that wage pressures and service sector inflation have cooled before relaxing their policy stance. 

Most of the improvement in UK inflation so far has been because of falls in energy prices and the levelling out of food price rises. Core inflation, stuck at 5.1 per cent in December, remains a worry. 

Some economists think there is already enough evidence to reassure the MPC that underlying price pressures are also easing, with services inflation well below the BoE’s November forecasts and growing signs that a weaker jobs market is slowing wage growth. 

“Inflationary pressures are abating, fast,” said Neville Hill, co-head of the consultancy Hybrid Economics, pointing to sluggish economic growth, weak loan demand and several months of flatlining in factory gate prices. “Today’s CPI print exaggerates the risks of resurgence.”

But other analysts have warned that even if inflation drops below 2 per cent in the near term, the BoE could struggle to keep it on target if it loosens policy too soon, and is caught out by a rapid economic rebound or by a new global price shock stemming from geopolitical events. 

Michael Saunders, a former BoE rate-setter now at the consultancy Oxford Economics, warned this week that the so-called “second round” effects of the recent inflationary surge on wages and companies’ pricing strategies “have not diminished much”, and that the prospect of a swift near-term drop “does not necessarily signal that inflation will be sustainably back to target”.

Chris Hare, economist at HSBC, predicted interest rates would come down later and by less this year than markets have been pricing in.

“There’s a possibility that underlying UK inflation pressures have not been entirely banished,” he said.