Inflation Relief to be Short-lived

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UK inflation undershot expectations in December, but it will pick up again as businesses pass the cost of tax hikes to customers.

Inflation retreated in December but economists say it will record a notable rise in January as base effects from last year's big fall work through the data.

Most economists then expect inflation to fall back again in subsequent months, but this benign view will be challenged by developments on the ground as businesses react to tax hikes due to come into force in April.

"Today’s slight dip in the inflation rate is welcome but it’s not a game-changer. Underlying price pressures within the economy are clear following the Budget. The path ahead on interest rates this year is likely to remain slow and cautious," says Stuart Morrison, Research Manager at the British Chambers of Commerce.

UK inflation eased to 2.5% in December from 2.6% in November and undershot a consensus estimate for a rise to 2.7%.

Core inflation rose 3.2% y/y in December, down from 3.5% and below the estimate of 3.4%. Importantly, service inflation, closely watched by the Bank of England, fell from 5.0% to 4.4%.

Above: Bigger picture, the dininflation process has stalled.

The undershoot has led many economy watchers to suggest the Bank will accelerate the pace as it cuts interest rates, which will potentially weigh on the pound but boost sentiment amongst borrowers.

"The fall in inflation was surprising and a welcome relief following the negative market developments we have seen this early in 2025," says Matt Lewis at TopMoneyCompare.com.

There is growing evidence that relief will be short-lived as the impact of October's budget start to take hold, leading economists to warn inflation will hit 3.0% before it hits 2.0% again.

The following changes will show up in upcoming inflation data prints:

1. unfavourable base effects whereby current data is mechanically boosted as it compares to a fall in the previous year's set of data
2. rising energy prices
3. increased bus fares from January)
4. VAT on school fees from January
5. rise in alcohol duty from February
6. higher water charges from April
7. rising vehicle excise duty from April
8. higher national insurance contributions from April
9. a large rise in the national living wage, also due in April)
10. a rise in university tuition fees from October

"While some may interpret December's figure as a sign of easing pressure, it’s critical to recognize that the underlying dynamics of inflation remain unresolved. Core inflation indicators and structural drivers—such as energy prices, wage growth, and supply chain disruptions—continue to exert upward pressure," says Nigel Green, CEO of deVere Group.

Research from the British Retail Consortium (BRC) reveals that about two-thirds of chief financial officers warned they would pass on costs from the increase to employer national insurance contributions.

Above: Inflation expectations are on the rise again. Image courtesy of Nomura.

More than half said they would reduce staff hours, including overtime, while 46% said they would reduce store headcount, according to the BRC.

The BRC surveyed 52 large retailers in the three weeks to Dec. 9. According to the trade association, 70% of respondents said they were "pessimistic" or "very pessimistic" about trading conditions.

Retailers have been warning the £40BN of tax rises Reeves needs to help rebuild public services will further stoke inflation, as thin margins cause supermarkets and others to pass on costs to shoppers.

Food prices are expected to rise 3.5% this year, compared with 2.9% in 2024, the BRC said.

"It is inevitable that consumers will bear some of the burden," Helen Dickinson, chief executive at the BRC, said in a statement. "The majority of retailers have little choice but to raise prices in response to these increased costs, and food inflation is expected to rise steadily over the year."

Ruth Gregory, Deputy Chief UK Economist at Capital Economics, says these developments still won't be enough to stop inflation falling below 2.0% in 2026.

"Our forecast is that CPI inflation will rebound in January, perhaps to almost 3.0% and that inflation will be a bit higher than most expect in the first half of this year. But we expect it to drop below the 2% target next year as the persistence of inflation fades further," says Ruth Gregory, Deputy Chief UK Economist at Capital Economics.

Capital Economics thinks the market is underestimating the speed at which the Bank of England will cut interest rates as a result.

Currently, the market only sees about two cuts falling in 2025, while most economists think the Bank will want to maintain a quarterly approach to cutting rates.