The Bank of England’s first interest rate decision of 2025 will take place next week, and investors widely expect rate-setters to reduce borrowing costs for a third time.
This would bring the benchmark Bank Rate down to 4.5 per cent, down from a peak of 5.25 per cent reached in August 2023.
While economists almost unanimously expect a rate cut next week, this obscures the difficult dilemma facing rate-setters on the Monetary Policy Committee (MPC).
Although growth in the economy is very weak, inflationary pressures seem to be on the rise. These are five of the most important considerations MPC members will take into account before next Thursday.
Inflation
Source: ONS
The headline rate of inflation jumped back above the two per cent target at the end of last year, ending 2025 at 2.5 per cent.
Many economists anticipate that it will rise to around 3.3 per cent by the spring on the back of higher energy prices, a weaker pound and the impact of the Budget.
So, while inflation is much closer to the target than it was a few years ago, rate-setters are still looking to securely anchor inflation at two per cent.
Services inflation
Source: ONS
Splitting up the different components of inflation reveals a more complex picture. Services inflation stands at 4.4 per cent while goods inflation is at 0.7 per cent.
For almost all of last year, disinflation was driven by falling goods prices while prices in the services sector remained more or less unchanged.
Analysts expect this pattern to reverse this year, with early indications suggesting that services inflation will fall slowly but surely in 2025.
Officials at the Bank of England are likely to pay more attention to services inflation, because it is a better gauge of the underlying inflationary dynamics in the domestic economy.
Wage growth
Source: ONS
Elevated pay growth remains a major concern for policymakers, particularly due to signs that it accelerated at the end of last year.
Regular pay growth in the private sector rose to six per cent in the three months to November, its highest level since February last year.
This was roughly double the rates consistent with inflation remaining at the two per cent target.
Other indicators suggest that broader labour market conditions are loosening, which should weigh on pay growth in the longer term, but officials may still be uneasy about easing policy dramatically while wage pressures remain high.
Growth
Looking at pay growth and the expected uptick in inflation, one might think there would be little reason to cut rates in February, but that would ignore the slowdown in economic activity since the summer.
Most economists expected that growth would slow compared to the first half of the year, but the pace of the deceleration has surprised analysts.
GDP expanded just 0.1 per cent in November, following two consecutive months of contraction. Indeed, the economy has barely grown since the election back in July.
Surveys suggest that activity remains weak in the new year, while consumer and corporate confidence remain depressed too.
Retail sales
The most up-to-date officials figures on economic activity show the extent to which the economy has lost momentum.
Retail sales fell 0.3 per cent in December, capping off a very weak golden quarter for consumers in which sales volumes fell 0.8 per cent.
Looking through the volatility, the graph shows that retail sales had been trending upwards earlier in the year. But that trend has reversed.
The crucial question for the Bank of England is whether lingering price pressures can reinvigorate inflation even when demand in the economy is so weak.
Most economists think the answer is no, at least in the medium term. This will keep the Bank on track to cut rates three or four times in 2025.