UK inflation slowed sharply in January to 3% from 3.4%, slightly above the Monetary Policy Committee’s (MPC) 2.9% forecast. January’s figure marks the start of inflation returning to 2%, with the next big drop coming in April. That’s when last year’s roster of regulated price and tax hikes drops out of the annual comparison. It means the fall in inflation over the coming months is all but guaranteed, leaving the MPC to focus on labour market weakness. Easing wage growth and rising unemployment will be enough for the MPC to cut interest rates in March and probably again in the summer. The big question is whether inflation will remain at 2%, as the MPC forecasts, or start to rise again towards the end of the year.

Slowing food inflation drove UK CPI drop

January’s inflation easing was relatively broad-based, but non-core components like slowing food and non-alcoholic beverages price inflation slashed 11bps from the headline rate. Fuel inflation also turned negative, dropping to -2.2% from 0.9%.

Crucially, the evidence suggests that food and energy inflation are most salient when it comes to households’ inflation expectations. A noticeable easing here will therefore reassure the Bank of England (BoE) that inflation expectations will slow in the coming months.

We also saw the start of last year’s swathe of regulated price and tax hikes dropping out of the inflation figures. Education inflation, pushed up by the introduction of VAT on private school fees, slowed to 5.1% from 7.6%.

Admittedly, underlying inflationary pressures remain stickier. At 3.1%, core inflation is comfortably above the MPC’s 2.9% forecast. This is because services inflation remains much more stubborn than headline inflation. We estimate that the BoE’s measure of ‘underlying’ services inflation, which removes the impact of volatile and indexed components, rose to 4.4% in January from 4% previously.

All told, January’s big drop in inflation marks the start of a sharp decline that will bring inflation much closer to 2% by April.

Further falls for UK inflation, but outlook uncertain

Looking ahead, another big drop in inflation in April is already baked in because more of last year’s big rises in regulated prices and tax hikes will drop out of the annual comparison. The Chancellor’s decision in the Autumn Budget to freeze rail fares and cut electricity bills will also knock around 0.5ppts off inflation.

Sharply slowing headline inflation combined with cooling pay growth and rising unemployment makes a March rate cut all but guaranteed. It also probably means there’ll be one more cut in the summer.

The big question is what happens in the second half of the year. The MPC has set itself a high bar by forecasting inflation to remain at 2% and even drop to 1.7% at the start of 2027 as labour market weakness weighs on inflation. However, we think there’s a reasonable chance inflation will rebound towards the end of this year for a couple of reasons.

First, administered price hikes will start putting upward pressure on inflation again later this year. From September, the government will gradually start to reverse the temporary 5p cut to fuel duty. From October, it’ll also introduce a new vape tax.

More importantly, underlying inflation will remain stickier − despite the headline rate returning to target. In fact, most private sector surveys point to services disinflation having little further to run. This would make the MPC’s hawks concerned inflation will rebound later this year if rates are cut too quickly. Indeed, Bank of England Chief Economist, Huw Pill, recently stated: “Progress with disinflation is ongoing, but it’s not quite as rapid or as convincing as we might have hoped 18 months ago.” If inflationary pressures regained momentum, then that may convince the MPC to slow the pace of easing further.

All told, today’s inflation fall means a March rate cut is almost a sure bet. Inflation will drop sharply in April to around 2%, which will give the MPC room to focus on the weak labour market. That will likely pave the way to another cut, or potentially even two, later this year if the jobs market fails to recover. However, the risks to inflation remain to the upside, which could force the MPC to stay on the sidelines if these materialise. In any case, most of the MPC’s focus has now shifted to the labour market. This means our base case is for UK interest rates to end the year at 3.25%.

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