UK inflation picked up unexpectedly for the first time in 10 months, a setback that’s likely to temper discussion about when the Bank of England can reduce interest rates.

The Consumer Prices Index rose 4 per cent from a year earlier in December, up from a 3.9 per cent increase the previous month, the Office for National Statistics said Wednesday. That was above economists’ expectations for a slight fall to 3.8 per cent. Core inflation stripping out food and energy held at 5.1 per cent.

The figures could prompt traders to rein in bets on the BOE cutting interest rates as soon as May. Softer inflation and wage data had fueled expectations of a string of rate reductions throughout 2024 despite BOE Governor Andrew Bailey sticking by his higher-for-longer messaging. It’s also possible January’s figures show an increase as well due to higher household energy bills.

“Today’s inflation figures show it isn’t ‘job done,’” said Alpesh Paleja, lead economist at the Confederation of British Industry. “Risks to the inflation outlook remain very much to the upside. In the near-term, Ofgem’s lifting of the energy price cap in January will likely lead to a small bump in the CPI rate.”

Investors pared back bets on BOE rate cuts. Markets now only see a 60 per cent chance of a reduction in May, which was almost certain just a few days ago. A total of four quarter-point reductions are fully priced in this year, down from five at the start of 2024.

“The rise in inflation today suggests that the market has got ahead of itself in expecting early rate reductions,” said Ed Monk, associate director at Fidelity International. “Today’s reading is a setback. The last portion of above-target inflation may prove the most difficult to shift.”

The acceleration in the UK mirrors a similar pick up in price pressures seen in the US inflation figures last week, which also dented expectations for an early rate cut slightly. Inflation there had risen to 3.4 per cent in December from 3.1 per cent.

The ONS said underlying price pressures being closely watched by the BOE also were stronger than expected in December. Services inflation — which BOE officials are watching for signs of underlying pressures on prices — accelerated to 6.4 per cent in December from 6.3 per cent in November.

There were signs that inflation was also boosted by spending in the run-up to Christmas. Clothing price inflation jumped to 6.8 per cent , while computer game consoles, sports equipment, toys and DVDs also helped to drive prices higher in the recreation and culture category.

The figures suggest that few retailers were being forced to discount to prop up demand in the festive season, perhaps hinting at a stronger showing in December retail sales figures due out on Friday. The British Retail Consortium remained gloomy about the outlook, saying they’re suffering higher prices.

“Despite retailers’ efforts to deliver an affordable Christmas for everyone, high input costs increased inflation rates in furniture and household equipment,” said Kris Hamer, director of insight at the BRC. “Retailers face a number of extra costs this year that threaten the progress made to reduce prices.”

Food inflation continued to slow, dropping to 8 per cent from 9.2 per cent in November. That was more than offset by an increase in alcohol and tobacco prices, which rose by 12.8 per cent from a year ago.

The sharp increase in alcohol and tobacco prices was largely due to tax rises on tobacco in the Autumn Statement, the ONS said. Tobacco prices rose by 4.1 per cent between November and December compared with a 0.3 per cent rise between the same two months last year.

Inflation is still running well below where the central bank had predicted in its November forecasts, which has allowed Prime Minister Rishi Sunak’s government to take credit for meeting its pledge to cut the level of price increases in half last year. Chancellor of the Exchequer Jeremy Hunt said he’d continue those efforts.

“As we have seen in the US, France and Germany, inflation does not fall in a straight line, but our plan is working and we should stick to it,” mr Hunt said in a statement. “We took difficult decisions to control borrowing and are now turning a corner, so we need to stay the course we have set out, including boosting growth with more competitive tax levels.”

Forecasters have predicted that inflation could be back at the BOE’s 2 per cent target by April when another sharp drop in household energy bills is expected. That would be much sooner than the BOE had expected last month when the central bank predicted a return to target only by the end of 2025.

“Despite a December rise, inflation is expected to continue falling this year” said Yael Selfin, chief economist at KPMG UK. “The expected overall improvement in the outlook for inflation, coupled with the slowdown in the domestic economy, will likely put the Bank of England in a position to begin cutting interest rates from the second half of the year.”

Wednesday’s data cap a series of reports showing inflationary pressures easing. The economy shrank more than expected both in the second quarter and in October and November, putting the UK on the brink of recession. In the labor market, job vacancies are falling and wages rising more slowly than economists had expected, reliving another upward force on prices.

Those reports have prompted traders to bet on the first rate cut coming as soon as May, followed by four more quarter-point reductions by the end of the year.

“Inflation may give us a slightly bumpy ride during the next couple of months,” said Roger Barker, director of policy at the Institute of Directors. “Next month’s figure will have to incorporate a 5 per cent rise in the Ofgem utility price cap from January 1st, and could also therefore tick upwards. However, inflation in the economy is still broadly moving in the right direction.”

Pipeline inflation pressures continued to ease, with both producer input and output prices falling in December at a faster pace than economists had forecast. The cost of fuel and raw materials was 2.8 per cent lower than a year earlier, reflecting falls in the price of chemicals and crude oil.

In a warning about persistent inflation pressures, however, services producer prices rose 3.6 per cent in the year through the fourth quarter, up from 3.5 per cent in the third. - Bloomberg L.P.