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Consumer prices increased 3% from a year earlier, accelerating from a 2.5% pace in December, the Office for National Statistics said Wednesday. It was above the 2.8% forecast by economists and the Bank of England.

However, traders took some comfort from lower-than-expected price growth in the services sector — which is being watched closely by the BOE for signs of domestically generated pressures. While it accelerated to 5% last month from 4.4%, the BOE had predicted services inflation of 5.2%.

The pound pared earlier gains due to softer-than-forecast underlying inflation. Sterling traded little changed at $1.2617, after hitting a fresh two-month high earlier at $1.2640. Traders were fully pricing in an additional two quarter-point cuts by the BOE in 2025 as of the end of Tuesday’s trading session.

The figures, which follow resilient labor market data on Tuesday, support the BOE’s cautious approach to cutting interest rates to support a moribund economy. While Governor Andrew Bailey has played down the threat from an expected surge in inflation this year, officials say they can’t rule out “second-round effects” keeping underlying pressures higher for longer. The BOE expects inflation to peak at 3.7% in the third quarter on the back of energy costs.

Higher inflation makes a March interest rate cut by the BOE “improbable,” said Suren Thiru, economics director at the Institute of Chartered Accountants in England and Wales. “These figures confirm a disheartening rebound in inflation as rising air fares and the introduction of VAT on private school fees contributed to notably widen the gap with the Bank’s 2% target.”

One driver of services inflation was the controversial introduction of 20% VAT on private school fees, a flagship policy of the Labour government designed to help fund improved public services. Private-school fees rose almost 13% in January, lifting annual inflation in education to 7.5% — the highest in almost a decade. Another was air fares, which fell by much less last month than in January 2024 due to the timing of flights over Christmas and New Year.

What Bloomberg Economics says...

“The faster-than-expected pick up in inflation will make for an uncomfortable reading for the Bank of England but it’s unlikely to set alarm bells ringing – the surprise was explained by food inflation.

“More importantly, services inflation was a cooler than expected.”

—Ana Andrade and Dan Hanson, economists. Click to read the REACT on the Terminal

Food inflation also jumped from 1.9% to 3.1%, driven by the cost of essentials such as meat, bread and cereals, while motor fuels edged higher in contrast to a fall a year earlier. Core inflation, which strips out volatile items like energy, food, alcohol and tobacco, rose to 3.7%, the highest since April.

“I know that millions of families are still struggling to make ends meet” despite the return of real wage growth, said Chancellor of the Exchequer Rachel Reeves. Higher prices will be a worry for the Labour government, which has fallen sharply in the polls since its election last July. The Conservatives blame the £40 billion ($50.5 billion) of tax rises announced in the October budget for intensifying cost pressures for businesses and households.

The latest pickup pushes inflation away from the BOE’s 2% target and is expected to be followed by further increases fueled by energy bills later this year. On Tuesday, Cornwall Insight Ltd. predicted another increase in the energy-price cap in April, marking a third consecutive quarter of rising gas and electricity bills for households.

However, the Monetary Policy Committee is also facing a stagnant economy, which has barely grown since Labour won power. That’s fueling divisions, with two of its nine members voting for a bumper half-point cut earlier this month.

“The worst-case scenario for UK business is stagflation, combining high inflation and low growth,” said Roger Barker, director of policy at the Institute of Directors. “January’s inflation figures have done little to mitigate the risk of this outcome.”

The central bank lowered interest rates by a quarter-point on Feb. 6, the third cut since August, but warned that further reductions would be “gradual and careful.” Money markets are pricing in just two more reductions this year to 4%.

The case for a cautious approach was also supported by figures on Tuesday showing wage growth at an eight-month high in the fourth quarter and the jobs market holding up stronger than expected. Tax data showed that the number of payrolled employees rose in January. Employment is down less than 20,000 since the budget, when Reeves increased payroll taxes for firms and announced another big increase in the minimum wage.

“Hot on the heels of strong wage data yesterday, this morning’s hotter-than-expected inflation print will raise alarm bells at Threadneedle Street,” said Zara Nokes, global market analyst at JP Morgan Asset Management. “This week’s data will cause quite the headache for the Bank of England and raises questions about the decision to cut interest rates this month.”

The figures also showed signs of rising pipeline price pressures. Factory gate prices for goods before they reach retailers were up 0.3% in January, faster than the 0.1% forecast. Producer input prices of raw materials fell 0.1% in January, less than the 0.6% decline predicted.

--With assistance from Harumi Ichikura and Joel Rinneby.