UK inflation falls to 3.4% in February

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UK inflation has fallen to its lowest in more than two years, coming in below forecasts and bolstering traders’ expectations of interest rate cuts by the Bank of England this summer.

Consumer prices rose at an annual rate of 3.4 per cent in February, down from 4 per cent in January, the Office for National Statistics said on Wednesday. 

The slowdown, driven in part by an easing in food price growth, left headline inflation lower than the 3.5 per cent rate forecast by economists in a Reuters poll and at its lowest level since 2021.  

Core inflation, which excludes food and energy, fell to 4.5 per cent in February from 5.1 per cent previously. Analysts had predicted a reading of 4.6 per cent.

The figures prompted traders in the swaps market to increase bets that the central bank could start cutting its benchmark rate, which stands at 5.25 per cent, from June.    

Traders are now pricing a 63 per cent probability of a quarter-point cut by that month, up from 58 per cent before the data was released. Two-year gilt yields, which reflect interest rate expectations, were down 0.04 percentage points at 4.22 per cent.

Sterling also nudged lower after the figures, falling 0.2 per cent against the dollar at $1.2694.

The fall in consumer prices was gratefully seized upon by chancellor Jeremy Hunt, who has been urging Conservative MPs to hold their nerve after two weeks of party turmoil.

“The plan is working. Inflation has not just fallen decisively but is forecast to hit the 2 per cent target within months,” said Hunt, who on Tuesday hinted at a general election in October.

But Rachel Reeves, shadow chancellor, said working people remained worse off despite the figures. “Prices are still high, the tax burden is the highest it has been in 70 years and mortgage payments are going up,” she said.

The BoE in February predicted that price growth was on track to drop to its 2 per cent target in the second quarter of the year thanks to falling energy costs, and Wednesday’s figures leave it on track to reach that level as soon as April.

“We expect inflation to undershoot the 2 per cent target for much of the second half of the year; this should allow the Bank to begin gradually cutting interest rates from the summer onwards,” said Yael Selfin, chief economist at advisory firm KPMG UK. 

Nevertheless, the BoE has insisted it cannot yet relax monetary policy given stubborn growth in services prices and wages, warning of the risk of price growth regaining traction. Markets expect the central bank to keep interest rates unchanged when policymakers next meet on Thursday.

Service price inflation eased to 6.1 per cent from 6.5 per cent in January, the ONS said, in line with BoE expectations.

Arguments for the BoE’s tough monetary policy stance to be continued hinge on the outlook for services inflation, which officials see as a key gauge of domestic pricing pressures as external drivers of inflation such as elevated fuel prices fade. 

Neville Hill of Hybrid Economics, a consultancy, said that while the ONS figures showed easing goods price inflation, services price growth remained “stickier”.

“Many central bankers, not least from the Bank of England, have pointed to this strength in services prices as a clear risk that overall inflation will remain high, warranting ongoing restrictive monetary policy. This morning’s numbers will do nothing to assuage those specific concerns,” he added.

The central bank is also keenly watching labour market indicators, notably wage gains. Excluding bonuses, annual wage growth slowed to 6.1 per cent in the three months to January in the UK, from 6.2 per cent previously, still well above the level that would be comfortable for the BoE.

The central bank’s Monetary Policy Committee last raised the cost of borrowing in August, pushing its key rate to a 16-year high of 5.25 per cent. The MPC has since left rates unchanged, although its nine members were split three ways when they last met in February.

Holding UK rates on Thursday would chime with the approach taken by the US Federal Reserve and European Central Bank, which have both signalled they will start reducing rates only when they have enough evidence that inflation is heading durably lower.

Surging prices have imposed a heavy toll on UK household finances, and even after the recent inflation slowdown the high level of prices is putting pressure on living standards.

The latest forecasts from the Office for Budget Responsibility, the independent fiscal watchdog, show that per-person real household disposable incomes will recover their pre-pandemic peaks only by 2025-26.