By Suban Abdulla and David Milliken

LONDON (Reuters) -British inflation slowed unexpectedly last month and core measures of price growth – tracked by the Bank of England – fell more sharply, according to official data that will be welcomed by Finance Minister Rachel Reeves after a market selloff.

The annual rate of inflation edged down to 2.5% in December from 2.6% in November, the Office for National Statistics said, in contrast to economists’ expectations in a Reuters poll for it to remain unchanged.

Inflation is expected to rise again due to higher energy prices, continued fast wage growth and temporary stimulus in October’s budget, and many analysts forecast it will top 3% in early 2025. Reeves said there was “still work to be done”.

But investors increased their bets on the BoE cutting interest rates, putting an 84% chance on a first quarter-point reduction on Feb. 6, the date of its next scheduled monetary policy announcement.

Two rate cuts for 2025 were fully priced into the market, up from around a 60% chance before the data.

British government bond yields dropped from multi-decade highs hit in previous days. Sterling fell after the figures were published but then reversed course to be broadly unchanged on the day.

The BoE has said Britain’s persistent inflation pressure means it will move only gradually with reducing borrowing costs despite signs that the economy is losing momentum.

The likelihood of slow rate cuts has contributed to a jump in borrowing costs that has threatened to knock Reeves off target for meeting her budget rules, possibly requiring her to cut public spending.

“For now, this slightly softer report should help reassure investors that the BoE can continue with its gradual easing cycle, and we expect the next rate cut in February,” Luke Bartholomew, deputy chief economist at abrdn, said.

The BoE forecast in early November that inflation would be 2.5% in December before rising to around 2.75% in the second half of 2025.

“Policymakers and Treasury officials will be breathing a small sigh of relief,” Scott Gardner, investment strategist at J.P. Morgan-owned digital wealth manager Nutmeg, said.

CORE MEASURES SLOW

The fall in the headline CPI rate reflected cheaper hotel rooms, air fares and clothes and a smaller rise in tobacco prices than in 2023.

The ONS said part of the 26% fall in air fares compared with December 2023 might have been because this December – unlike in 2023 – data was collected for fares with return flights on Christmas Eve or New Year’s Eve. These are unpopular dates for return travel.

Underlying measures of price growth, which the BoE sees as a better guide to medium-term price pressures, also slowed by more than expected.

Core inflation, which excludes energy, food, alcohol and tobacco prices, fell to 3.2% from 3.5% in November.

Services inflation stood at 4.4% in December – its lowest since March 2022 – compared with 5.0% a month earlier, the ONS said. Economists had forecast it would dip only to 4.9%.

“Are we on a linear path down for inflation? We don’t think so,” Sanjay Raja, Deutsche Bank’s chief UK economist, said, pointing to increases in April in the minimum wage and employers’ social security contributions as well as higher energy and food costs.

“That said, the jump in price momentum will likely be temporary, with price inflation expected to normalise to more target-consistent levels next year.”

Factory gate prices in December were 0.1% higher than a year earlier after November’s 0.5% drop.

(Reporting by Suban Abdulla and David MillikenEditing by William Schomberg, Barbara Lewis and Sharon Singleton)

---