Inflation in the United Kingdom held steady at 4% in January, defying forecasts of a rise, official data showed Wednesday, as lower food prices helped offset an increase in energy costs, in a relief for the Bank of England (BoE) and Prime Minister Rishi Sunak too ahead of a national election expected this year.

Consumer price inflation – which was higher in Britain than in other rich economies until recently – is expected to fall further in the coming months, paving the way for the BoE to start cutting borrowing costs from their 16-year high.

Sterling weakened against the dollar and the euro immediately after the inflation data was published.

The January reading was better than expected as most economists expected inflation to rise modestly to around 4.2%.

Investors added to their bets on the BoE cutting interest rates this year, putting a roughly 72% chance of a first reduction coming in June, compared with only a 40% chance on Tuesday after a surprise jump in U.S. inflation.

"Overall, the latest inflation data should reassure the Monetary Policy Committee (MPC) that the time to start cutting interest rates is approaching," Martin Beck, chief economic advisor to the EY ITEM Club, said.

Still, the central bank policymakers "are a very wary lot and will want more evidence that inflation will hug the (BoE) target... rather than drift upwards again before they are confident about cutting rates," said Susannah Streeter, head of money and markets at Hargreaves Lansdown.

"However, given this slightly better-than-expected reading, the prospect for rate cuts this year is more encouraging."

Higher gas and electricity bills were the main upward contributor to U.K. inflation in January, but this was offset by falling prices for furniture and food, which dropped month-over-month for the first time in more than two years.

The Office for National Statistics (ONS) said the main downward contribution to the figure was a monthly drop in food prices of 0.4%, which was the first since September 2021.

"This is welcome news for low-income households who spend a higher proportion of their income on food," said Lalitha Try, an economist at the Resolution Foundation think tank.

"The cost of second-hand cars went up for the first time since May," ONS chief economist Grant Fitzner also noted.

Britain's core inflation, which excludes volatile food, energy, alcohol and tobacco prices, was also unchanged at 5.1%, the ONS said.

Services inflation – an indicator of domestic price pressures – rose to 6.5% from 6.4% in December but was not as strong as the BoE had expected.

The British central bank fears rapid wage growth – which makes up much of the inflation rate in the services sector – could add more inflationary pressure across the economy.

Data published on Tuesday showed regular wages rose by an annual 6.2% in the last three months of 2023, the slowest increase in more than a year but about double the pace the BoE views as consistent with getting inflation back sustainably to 2%.

"Inflation never falls in a perfect straight line, but the plan is working," Treasury chief Jeremy Hunt said.

"We have made huge progress in bringing inflation down from 11% and the Bank of England forecast that it will fall to around 2% in a matter of months."

Living standards hit

Though interest rates appear to have peaked, the Bank of England has expressed caution about cutting interest rates too soon as lower borrowing rates may bolster spending and put renewed upward pressure on prices.

The bank has managed to get inflation down from a four-decade high of more than 11%, by raising its main interest rate aggressively from near zero to 5.25%.

It has held the rate there since August and there are hopes that cuts may soon be on the agenda, once there is clear evidence that inflation will remain around the 2% target for a period of time. The bank's last set of forecasts earlier this month showed inflation remaining above the target for much of this year and next.

Suren Thiru, economics director at the Institute of Chartered Accountants in England and Wales, said the journey back to the target "should now accelerate," with a sizeable fall in energy bills from April and lower food costs likely.

"While interest rates could start falling over the summer, large tax cuts in next month's budget would risk pushing the Bank of England to keep policy tighter for longer by refueling concerns over inflation," he said.

MPC member Jonathan Haskel, one of two policymakers who voted to raise interest rates at the BoE's most recent meeting, last week told Reuters he would need to see more evidence of inflation pressures weakening before changing his stance.

Samuel Tombs, an economist with Pantheon Macroeconomics, estimated that a gauge of core services prices that the BoE is watching closely fell by 0.2% month-over-month.

High inflation has impacted British households' living standards over the last couple of years, contributing to the electoral challenge facing Sunak whose Conservative Party is lagging far behind the opposition Labour Party in opinion polls.

Inflation was first stoked by supply chain issues during the coronavirus pandemic and then Russia's full-scale invasion of Ukraine, which pushed up food and energy costs.

While the interest rate increases have helped in the battle against inflation, the squeeze on consumer spending, primarily through higher mortgage rates, has weighed on the British economy, which is barely growing.

Whatever happens on the interest rate front in the coming months, relatively high borrowing rates and low economic growth will likely be the backdrop for the general election which has to take place within a year.

Separate ONS data added to signs of weaker inflation pressures ahead as prices paid by manufacturers fell by an annual 3.3%, the biggest fall since May 2020. The prices they charged also dropped, down by 0.6%, the biggest fall since November 2020.

The weakening inflation outlook is likely to help Britain's economy grow moderately in 2024, although official data on Thursday is likely to show that it slipped into a shallow recession in the second half of 2023, according to the analysts polled by Reuters.