Inflation Drops, But Perhaps Not For Long

Inflation fell to 2.5% in December from its previous November figure of 2.6%, providing a little relief for Chancellor Rachel Reeves. This was also below City analysts’ forecasts, and was therefore a little unexpected.

Government borrowing has risen to its highest level in decades, and there has been some significant turbulence in the UK government bond markets over the past week. Long-term government bond borrowing costs have risen to their highest level since the late 1990s (remember them?) leading some to think that the chancellor will raise taxes (again) or cut spending to meet her fiscal rules.

As a result of the rise in bond yields, the UK’s debt interest bill rose to more than £100bn annually. These increased interest payments would partly erode the nearly-£10bn ‘cushion’ against Reeves’ fiscal rules to cut debt as a share of the economy and balance spending with tax revenues.

Bond yields fell sharply on this news today (Wednesday 15th January). Bond yields move inversely to prices.

The yield on the benchmark 10-year bond dropped to 4.81%, by 10 basis points, and the yield on the 30-year bond dropped to 5.38%, a fall of 8 basis points.

The FTSE 100 rose by 0.64% on the news, to 8,254.02, and the Pound also strengthened against the US Dollar by 0.18% to $1.22 and also against the Euro to €1.18 (a rise of 0.16%).

Ruth Gregory, deputy chief UK economist at Capital Economics, said the inflation data would be “welcome news for the Bank of England and Chancellor”.

Reeves has been under pressure to revisit her economic agenda following the volatility in the bond markets. The coming weeks could see her provide more details of her plan for growth. According to Reeves “the prize on offer to the British public is immense”. Hmmm.

As we have reported previously, businesses have warned of price increases to deal with the £25bn rise in employers’ National Insurance Contributions outlined in the October budget, as well as the increase in the Living Wage.

Thomas Pugh, an economist at the consultancy RSM UK, said: “December’s dip in inflation won’t last long. The combination of firms passing through the large increase in labour costs imposed by the budget, increases in taxes and rising energy prices means inflation will breach 3 per cent in the spring.” This would then trigger Andrew Bailey at the Bank of England having to write to the Chancellor to explain why inflation had exceeded the central bank’s target.

The Monetary Policy Committee (“MPC”) decided in December to hold interest rates as they currently are.