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Source: CNBC

UK inflation unexpectedly rose for the first time in five months, climbing to 3.4% in December and complicating the timeline for a potential interest rate cut from the Bank of England.

Data from the Office for National Statistics (ONS) confirmed the annual inflation rate, as measured by the consumer prices index (CPI), increased from 3.2% in November. This figure surpassed City economists' forecasts of a more modest rise to 3.3% and marks a reversal after months of falling or stagnant price growth.

While analysts believe the uptick is likely temporary, financial markets have almost entirely priced out the possibility of an interest rate cut by the Bank of England next month.

What's Driving the Price Spike?

The December inflation increase was largely fueled by volatile items and specific policy changes, rather than a broad resurgence in price pressures.

Key drivers include:

• Air Fares: A significant 28.6% surge in air travel costs occurred in December. While flight prices typically jump over the Christmas holiday, the increase was magnified when compared to an unusually low base in 2024.

• Tobacco Duties: Higher taxes on tobacco products, introduced by Chancellor Rachel Reeves in the autumn budget, took effect in December and contributed to the headline rate.

Martin Beck, chief economist at WPI Strategy, advised against alarm, stating, "December's uptick in inflation should not set alarm bells ringing. The increase was largely driven by temporary and technical factors, not a broader resurgence in price pressures."

A Deeper Look at the Inflation Data

Beneath the headline figure, the details paint a more complex picture of the UK economy. Core inflation, which excludes volatile food and energy prices, remained unchanged from November at an annual rate of 3.2%. This stability suggests underlying price pressures may not be accelerating.

However, the cost of groceries continued to climb over the holiday period. Annual food inflation rose to 4.5% from 4.2% in November, with the ONS highlighting rising prices for bread and cereals as a primary factor.

Figure 1: UK food inflation rose to 4.5% in December, with the ONS identifying rising prices for bread and cereals as a key driver.

Services inflation, a key metric for the Bank of England, edged up from 4.4% to 4.5%. Although this measure is watched closely for signs of domestic price pressures, the December rise was smaller than economists had feared.

Yael Selfin, chief economist at KPMG UK, noted that the Bank of England would likely look through this increase. "Despite services inflation increasing in December, this was not reflective of domestically generated price pressures and was largely driven by volatile categories, such as air fares," she said, adding that slowing wage growth should help ease services inflation in the coming months.

Bank of England Rate Cut Timeline Pushed Back

The stronger-than-expected CPI reading has prompted the Bank of England's Monetary Policy Committee (MPC) to maintain a cautious stance. City traders now see an interest rate cut in February as highly unlikely and are not fully pricing one in until June.

Despite the market's reaction, many economists still forecast a potential rate cut in April, provided that UK price and wage growth continue to soften. Bank of England Governor Andrew Bailey stated last month that he expects inflation to return to the MPC's 2% target by the middle of this year.

Economic Outlook and Government Response

Chancellor Rachel Reeves, who has made tackling the cost of living a central theme, pledged that 2026 would be the "year that Britain turns a corner" on inflation. "My number one focus is to cut the cost of living," she said, referencing measures from the budget including discounts on energy bills and freezes on rail fares and prescription charges.

In a separate report, the ONS revealed that private rental price growth is slowing. Average monthly rents increased by 4% in the year to December, down from 4.4% in November and the slowest pace since May 2022. Property portal Zoopla attributes this shift to an increase in available rental homes, as more first-time buyers are leaving the rental market due to improved mortgage conditions and slower house price growth.

Political turbulence is rattling UK markets, with fresh doubts over Prime Minister Keir Starmer’s leadership sending the pound and long-term government bonds tumbling on Thursday.

Investors are increasingly pricing in a political risk premium as Starmer faces mounting pressure over his decision to appoint Peter Mandelson as US ambassador, despite his known connection to the disgraced financier Jeffrey Epstein. The market fallout signals growing concern that the Prime Minister’s grasp on power is weakening.

UK Yield Curve Steepens as Pound Falters

The market reaction was swift and clear. Sterling dropped as much as 0.4% to a near two-week low of US$1.36, making it the worst-performing currency among its peers.

In the bond market, the yield on 10-year government bonds, or gilts, climbed by four basis points to 4.59%. Because shorter-term rates remained relatively stable, the gap between the two-year and 10-year gilt yields widened to 86 basis points—its most substantial spread since 2018.

Figure 1: The spread between UK 2-year and 10-year gilt yields surged to 86 basis points, its highest level since 2018, as political uncertainty spooked investors in long-term debt.

"It's worth keeping a closer eye on the UK with PM Starmer under considerable domestic pressure," noted Jim Reid, global head of macro research at Deutsche Bank AG. He added that the weakness in gilts reflects investor concern that "he could be replaced."

Monetary Policy vs. Political Risk

The divergence in bond yields highlights where investors are focusing their attention. Longer-dated debt is highly sensitive to political and fiscal risk, while shorter-dated notes are primarily driven by central bank policy.

With the Bank of England expected to hold interest rates steady on Thursday, the front end of the yield curve has been anchored. "While gilts are watching politics, the front-end will be paying attention to today's BOE meeting," said Jamie Searle, a strategist at Citigroup Inc.

Searle explained that with recent UK data surprising to the upside, there is little pressure on the Monetary Policy Committee to act. "Yesterday's rise in political uncertainty adds to the cheapening," he added, referring to the sell-off in longer-term gilts.

Market Anxiety Over a Post-Starmer UK

For investors, the instability is not just about a potential leadership change but what might follow. The market consensus is that any replacement for Starmer or his chancellor, Rachel Reeves, would be less committed to the UK's current fiscal rules.

"This is negative for the currency not simply because political instability is undesirable, but because any change in leadership is likely to be interpreted as fiscally expansionary," one analyst noted. "Given the UK's long-standing challenges around debt financing, markets will undoubtedly react negatively to such developments."

This sensitivity has been tested before. Just two weeks ago, gilts sold off after a potential path opened for Greater Manchester Mayor Andy Burnham, a left-wing rival of Starmer, to return to Parliament. Burnham, who has criticized the UK's deference to financial markets, is seen as a potential challenger for the premiership.

The political headwinds arrive at a difficult time for Starmer, whose Labour party is struggling with dire polling numbers and who faces a record disapproval rating himself ahead of local elections in May.

Czech headline inflation plunged to a nine-year low of 1.6% year-on-year in January, a development fueled by falling energy costs that has intensified the debate over future interest rate cuts.

The preliminary data was released just as the Czech National Bank (CNB) convened for a policy meeting. The central bank has kept its main interest rate on hold at 3.50% since May 2025. That decision followed an easing cycle that began in 2023, which halved the rate from its 7.00% peak reached during the 2022-2023 inflation surge.

Inflation Plunges Below Expectations

According to the statistics office's flash estimate, the 1.6% annual inflation rate for January was slightly below the 1.7% forecast in a Reuters poll. Month-on-month, prices rose by an expected 0.9%.

Inflation has remained close to the central bank's 2% target since 2024, following a period where price growth reached double-digit levels.

Figure 1: Czech year-on-year inflation peaked near 18% in 2023 before a rapid descent brought the rate to its current multi-year low, stabilizing near the central bank's 2% target since 2024.

Sticky Service Prices Complicate CNB's Decision

Despite the sharp drop in the headline number, policymakers remain cautious due to underlying price pressures. A key concern is inflation in the services sector, which remained high at 4.7% year-on-year. Analysts agree that elevated core inflation and persistent price growth in services give the central bank reasons to remain vigilant.

The recent decline in energy costs was significantly influenced by a government policy decision. The administration of Prime Minister Andrej Babis shifted the burden of payments for renewable energy from households and companies to the state budget. The central bank typically does not adjust policy based on the primary impact of such regulatory changes.

In December, Governor Ales Michl confirmed the bank would not react to the measure and noted that inflation could fall below its target.

Rate Cut Outlook: A Shift in Tone?

Analysts believe price growth will likely remain below 2% for a sustained period. While most expect the central bank to hold rates steady at Thursday's meeting, the probability of a rate cut later this year is growing.

The discussion has gained momentum after some policymakers floated the possibility. In a late January interview with Reuters, Vice-Governor Jan Frait said the bank could discuss slight monetary easing, citing external factors that might lead other major central banks to cut rates.

This sentiment was echoed in market analysis following the latest inflation data.

"The probability of a further decrease in CNB interest rates this year has increased significantly," said Jan Bures, an economist at CSOB bank.

India has confirmed its exports will benefit from a sharply lower 18% U.S. tariff, but the change is not immediate as previously announced by Washington.

Commerce Minister Piyush Goyal clarified that the new rate, a significant drop from 50%, will only take effect after both nations sign a joint statement and the U.S. issues an executive order. This timeline differs from President Donald Trump's earlier statement that the reduction was "effective immediately."

Implementation Hinges on Formal Agreement

Goyal stated that the joint statement is expected to be signed within the next four to five days. Following the U.S. action, New Delhi will reciprocate by lowering its own duties on American goods around mid-March, but only once the formal agreement is officially in place.

While financial markets in India initially reacted positively to the news, the absence of official documentation has created confusion, even as leaders portray the deal as a reset in trade relations.

Uncertainty Lingers Over Deal's Full Scope

Prime Minister Narendra Modi’s government has confirmed the core tariff reduction on Indian goods but has not yet verified several other commitments outlined by President Trump. These unconfirmed claims include India agreeing to:

• Halt Russian crude oil purchases

• Import oil from Venezuela

• Reduce tariffs on some American products to zero

Deconstructing the $500 Billion Purchase Pledge

A key point of clarification from Indian officials concerns the announced $500 billion in purchases of U.S. goods. They explained that this figure is not entirely new business but is spread over a five-year period and incorporates deals that were already in the pipeline.

Goyal noted that existing aircraft orders from the U.S. could account for over $100 billion of that total. In recent years, major carriers including Air India Ltd., Akasa Air operator SNV Aviation Pvt., and SpiceJet Ltd. have collectively ordered 590 planes from Boeing Co.

Beyond aviation, Goyal added that India plans to increase its purchases of American energy, semiconductors, and electronic goods over the next five years.

French manufacturing output registered a 0.8% decline in December, a reversal from the 0.5% growth seen in November. However, a closer look reveals the drop was concentrated in specific, highly volatile sectors and does not signal a broader industrial slowdown.

Unpacking the December Decline

The negative headline figure was primarily driven by weaker production in transport equipment, a sector that makes up 13% of France's total manufacturing output. The aerospace segment, in particular, saw a sharp drop that erased the gains from the previous three months.

Such volatility is typical for the aerospace industry, and this one-month dip is not considered a cause for alarm. In fact, on a yearly basis, production of transport equipment is still up by a strong 12.4%.

While coke production also fell by 0.9% over the month, every other industrial sector reported an increase in output, underscoring the narrow scope of the December downturn.

A Positive Outlook for 2026

Despite the monthly dip, the forecast for French industry in the first half of 2026 remains optimistic. A cyclical improvement is expected, supported by several key factors:

• Regional Recovery: A broader European economic recovery is gaining momentum.

• German Stimulus: Germany's stimulus plan is anticipated to boost regional demand.

• Business Confidence: Improving business sentiment and healthier order books point to higher industrial production in the coming months.

• Defense Spending: Rising defense budgets will continue to support the industrial sector.

• Aerospace Strength: Aerospace production is projected to remain a significant driver of growth.

Potential Risks on the Horizon

However, the path forward is not without challenges. Several factors could weigh on economic activity and exports:

• Stronger Euro: The recent appreciation of the euro poses a risk to export competitiveness. The European Central Bank estimates that a further 4.3% rise in the euro against the dollar could reduce eurozone GDP growth by 0.1 percentage points.

• High Tax Burden: The high tax burden on French companies may constrain business activity.

• Weak Investment: Recent business surveys indicate that investment intentions remain very weak.

The Final Verdict: Modest Growth Expected

Balancing these positive drivers and potential headwinds, the overall outlook for 2026 is moderately positive. GDP growth is forecast to reach approximately 1%, a slight acceleration from the 0.9% growth recorded in 2025.