UK inflation unexpectedly fell in December, raising expectations that the Bank of England could reduce interest rates in the coming months.

Prices rose by 2.5% in the year to December, down slightly from 2.6% in November. This marks the first decline in inflation in three months, offering a glimmer of relief amid rising living costs. The drop was primarily driven by a fall in hotel prices and smaller-than-usual increases in airfares. Despite this improvement, prices continue to rise faster than the Bank of England’s target of 2%.

The latest figures are seen as a boost for Chancellor Rachel Reeves, who has faced mounting criticism due to the fall in the pound’s value and government borrowing costs reaching their highest levels in years.

“If it stays like this, we will be on route to slightly more interest rate cuts,” Michael Saunders, a former member of the Bank of England’s monetary policy committee, told the BBC.

Last month, the Bank of England opted to keep interest rates at 4.75% after the UK economy posted no growth between October and December. However, the latest inflation data strengthens the case for a potential reduction to 4.5% in February, according to Ruth Gregory, deputy chief UK economist at Capital Economics.

Increased investor optimism has led to growing bets on an interest rate cut next month, with many also anticipating further reductions by the end of 2025.

Easing price pressures in sectors such as restaurants and hotels helped pull inflation down in December. The Office for National Statistics (ONS) also reported a slower rise in tobacco product prices. However, the positive trends were partially offset by the rising cost of fuel and second-hand cars.

Grant Fitzner, chief economist at the ONS, noted that despite the overall drop in inflation, rising fuel prices and more expensive cars were contributing factors that limited the decline.

Following the release of the inflation figures, UK government borrowing costs fell to their previous week’s levels, and the pound strengthened slightly to $1.22. Debt costs in the UK further eased after US inflation figures showed a larger-than-expected drop in core inflation, despite the headline inflation figure rising.

Chancellor Reeves acknowledged that there was “still work to be done” to help families with the cost of living but pointed to the government’s actions, including protecting workers’ wages from higher taxes and increasing the minimum wage.

However, Shadow Chancellor Mel Stride criticized the government’s economic management, accusing it of stifling growth and calling for Reeves to explain how she plans to address the country’s economic challenges.

Natural gas and crude oil prices have surged sharply in January, driven by rising demand and new U.S. sanctions on Russia. The increase in energy prices poses significant risks to the eurozone’s inflation outlook and raises concerns about a potential stagflationary scenario for the region.

Benchmark natural gas futures at NYMEX spiked to $4.37 per million British thermal units (MMBtu), the highest level since December 2022, before retreating slightly on Monday. Crude oil futures, including WTI and Brent, also rose to their highest levels since August 2024, with WTI up by 17% and Brent climbing 14% since early December. The price hike in natural gas is largely attributed to soaring demand due to cold weather in the northern hemisphere, while the surge in crude oil prices follows new U.S. sanctions on Russian oil exports.

Natural gas prices have more than doubled since October 2024, rising from under $2 per MMBtu to just under $4. According to the U.S. Energy Information Administration, natural gas futures for delivery at the Title Transfer Facility (TTF) in the Netherlands averaged $14.55 per MMBtu for the week ending January 8, a 27% increase compared to the same period last year. The surge in oil prices also stems from the continued decline in U.S. oil inventories, which dropped for the seventh consecutive week by January 5, alongside sanctions imposed on Russian oil producers like Gazprom Neft and Surgutneftegaz.

The rising energy prices come at a precarious time for the eurozone, which is already facing economic challenges amid political uncertainties. Experts warn that higher energy costs could exacerbate inflationary pressures and hinder economic growth, pushing the region toward stagflation. Stagflation refers to an economy experiencing high inflation, stagnant growth, and rising unemployment—an increasingly plausible scenario for the eurozone.

Kyle Rodda, a senior market analyst at Compital.com, said, “If energy prices continue to rise, there is a risk of a stagflationary mix in Europe, which is struggling with energy policy and weak growth.” This mirrors the challenges the eurozone faced in 2022 when Russia’s invasion of Ukraine sent energy prices soaring. The European Central Bank (ECB) will likely be tasked with balancing inflation and economic growth, a difficult feat as energy prices remain volatile.

In November 2024, S&P Global projected eurozone GDP growth of just 0.8% in 2024 and 1.2% in 2025, contingent on falling energy prices and ECB rate cuts. However, a resurgence in energy prices could undermine these projections.

The situation may also be influenced by the incoming U.S. administration. President-elect Donald Trump has expressed intentions to broker a truce between Russia and Ukraine, potentially leading to a reversal of some sanctions on Russian energy exports. If such negotiations succeed, it could have a significant impact on global energy markets, though experts believe the chances of this happening remain low.