Key Takeaways
- The UK’s Consumer Price Index (CPI) rose to 3.4% in December, exceeding expectations of 3.3%
- The increase was driven by higher air fares and tobacco prices
- Despite the rise, economists expect inflation pressure to abate in the coming months
- The Bank of England is expected to cut interest rates in 2026, with markets pricing in one or possibly two quarter-point cuts
- Services inflation rose to 4.5% in December, while producer prices data showed a sharp uptick in the services sector
Introduction to UK Inflation
The UK’s inflation rate has risen to 3.4% in December, surpassing expectations of 3.3%. This increase was driven by higher air fares and tobacco prices, which were the biggest contributors to the headline rise in consumer prices. Despite this rise, economists remain optimistic that inflation pressure will ease in the coming months. The Bank of England is expected to cut interest rates in 2026, with markets pricing in one or possibly two quarter-point cuts. This decision is based on the expectation that the pace of price increases will slow sharply in the coming months as last year’s rises in utility costs and other government-controlled tariffs fall out of the annual comparison.
Causes of Inflation
The increase in inflation was largely driven by higher air fares and tobacco prices. The rise in air fares was due to the timing of flights around Christmas, while the increase in tobacco prices was caused by an increase in duty charged on tobacco products. These factors contributed to a 0.2% increase in the headline inflation rate, taking it to 3.4% in December. Despite this rise, the underlying trend remains that inflation is expected to slow in the coming months. The Bank of England’s Governor, Andrew Bailey, has said that inflation is likely to be close to the central bank’s 2% target in April or May.
Economists’ Predictions
Economists are sticking to their view that inflation pressure will abate in the coming months. Adam Deasy, an economist at PwC, said that "although the uptick is larger than expected, for now it’s a speed-bump, rather than an indication we are veering off course on the road to price stability." Nicholas Crittenden, economist from the National Institute of Economic and Social Research think tank, also said that "the Bank of England will… not be worried by these numbers" and that they still predict one cut in Bank Rate in the first half of this year. These predictions are based on the expectation that the pace of price increases will slow sharply in the coming months as last year’s rises in utility costs and other government-controlled tariffs fall out of the annual comparison.
Bank of England’s Response
The Bank of England is expected to cut interest rates in 2026, with markets pricing in one or possibly two quarter-point cuts. The central bank’s Governor, Andrew Bailey, has said that the Bank of England is watching the situation closely and is prepared to take action if necessary. However, Bailey also said that the Bank of England is worried about the impact of geopolitical developments on inflation, particularly with regards to the US-China trade tensions and the potential for tariffs on European allies. The Bank of England’s Monetary Policy Committee cut Bank Rate to 3.75% in December, but almost half its members voted for no change due to worries about the persistence of inflation pressure.
Impact on Markets
The reaction from financial markets to the inflation data was muted, with the pound and market expectations for BoE interest rates little changed. This suggests that investors are not overly concerned about the rise in inflation and are still expecting the Bank of England to cut interest rates in 2026. The markets are pricing in one or possibly two quarter-point interest rate cuts by the BoE in 2026, which is consistent with the expectation that inflation pressure will ease in the coming months. However, the situation is being closely watched, and any changes in the geopolitical landscape or unexpected increases in inflation could lead to changes in market expectations.
Conclusion
In conclusion, the UK’s inflation rate has risen to 3.4% in December, driven by higher air fares and tobacco prices. Despite this rise, economists expect inflation pressure to abate in the coming months, and the Bank of England is expected to cut interest rates in 2026. The central bank is watching the situation closely and is prepared to take action if necessary, but for now, the markets are pricing in a cut in interest rates and are not overly concerned about the rise in inflation. As the situation continues to evolve, it will be important to monitor the data closely and adjust expectations accordingly.
