Lower UK inflation gives Reeves breathing room and paves the way for rate cut Inflation

Rachel Reeves was deemed a “lame duck” chancellor in some headlines earlier this week as a brutal sell-off in bonds put her at risk of breaching fiscal rules.

Shadow chancellor Mel Stride even somewhat puzzlingly compared Reeves' situation to Shakespeare's tragic prince Hamlet, while Tory leader Kemi Badenock claimed Labor had chosen A chancellor who is “unqualified for the job”.

However, what financial markets take away, they can recover. Much of the gains in bond yields in recent days have been reversed after UK inflation fell below expectations of 2.5% on Wednesday morning.

If sustained, a sharp rise in yields on government bonds, known as gilts, could push up the government's borrowing costs, erasing the £9.9 billion in net worth Mr Reeves left behind to meet fiscal rules. Treasury insiders have strongly hinted that Reeves may cut spending if that happens.

The heated debate of recent days should now subside, at least for a while, giving Reeves and her ministerial colleagues some space on the news agenda to tout their growth plans.

The Bank of England's nine-member Monetary Policy Committee (MPC) is highly likely to cut interest rates to 4.5% at its next meeting on February 6 after an unexpected slowdown in inflation, which could provide a much-needed feel-good factor in the economy Weak factors.

U.S. inflation data released on Wednesday was in line with investor expectations, easing concerns about a resurgence of price pressures and boosting sentiment.

The rise in UK bond yields, which has largely moved inversely to prices, echoes similar moves in the US, where markets are bracing for Donald Trump to win the White House next week.

However, while the sell-off was driven by global concerns, it was partly driven by concerns that the UK was sliding towards “stagflation” – a bad combination of slow growth and sticky prices.

The UK consumer price index (CPI) in December was 2.5%, down from 2.6% in November, which alleviated people's concerns to a certain extent.

In particular, the core inflation rate, which excludes volatile factors such as energy, food, alcohol and tobacco, fell to 3.2% in December from 3.5% a month ago. These domestically induced price increases are what worries the central bank the most.

The cost of a night out or a weekend getaway appears to be a key part of this in December: the Office for National Statistics cited hotels and restaurants as a driver of the CPI decline.

On an annual basis, restaurant and hotel price inflation was 3.4%, down from 4% a month ago and the lowest since July 2021, before the economy fully reopened after the pandemic.

Food prices, a significant source of inflationary pressures in 2022 and 2023, rose 2% in the year to December, unchanged from November.

Retailers have warned they may raise prices in the coming months as budget changes announced by Reeves, including a £25bn increase in employers' national insurance contributions, will drive up business costs from April. But for now, CPI inflation appears to be moving in the right direction.

Market focus will now turn to Thursday's November GDP data: a test of the growth part of the stagflation picture.

The weaker-than-expected data could spark another market swing in the coming days; but for now, Reeves can start touting growth again.