Many in the City interpreted last week’s interest rate decision as a decisive victory for the Bank of England’s doves, signalling the start of a long and overdue fall in borrowing costs.
There’s a clear case to be made. The Monetary Policy Committee (MPC) was unanimous in calling for interest rates to head lower while the Bank of England also slashed its growth forecasts.
It suggests that policymakers have grown more concerned about the health of the economy than lingering inflationary risks.
Some might cheer for the decision. A succession of investment banks have predicted that the Bank could cut rates five or six times this year, largely due to the weakness in the economy.
But if you take the Bank’s latest forecasts seriously, then this is not going to happen.
Inflation to pick up
According to the central bank’s forecasts, the headline rate of inflation will rise to 3.7 per cent later this year, only returning to target towards the end of 2027.
The main reason for the increase is higher energy prices, which are around 20 per cent higher than in the Bank’s November forecasts.
Source: Bank of England
The MPC was willing to cut rates, despite the pickup in inflation, because it judged that higher energy prices would not spark so-called second-round effects.
Second-round effects capture the knock-on impacts of higher input costs. Think firms raising prices to maintain their margins, and workers demanding a pay rise as things get more expensive.
These are the things that the Bank of England is really worried about. After all, domestic monetary policy cannot impact the international gas market.
The basic hope is that the increase in energy prices is just so much smaller than the aftermath of Russia’s invasion of Ukraine, that the same second-round effects won’t materialise.
In addition, the economy is also much weaker than it was immediately post-pandemic, when there was a surge in demand following the lockdowns.
But Bank officials – while more relaxed than three years ago – are clearly still worried by the prospect of some knock-on effects.
The Monetary Policy Report expressed concern that the “threshold for second-round effects may now be somewhat lower,” simply because inflation has been above two per cent for so long.
And while the economy is weak, that is a direct and intended consequence of tight monetary policy. Cutting rates aggressively would strengthen demand, enabling firms to pass on higher costs.
Its worth remembering that these forecasts were based on the assumption that rates would only be cut twice in 2025, with one further cut anticipated in 2026.
Cutting six times this year would presumably stoke inflationary pressures even further, and risk generating the second-round effects that policymakers are worried about.
It is also clear that domestic price pressures are still more prevalent than policymakers would like.
Alongside its rate decision, the Bank also published its latest survey of pay settlements, which suggested that firms expect to raise base pay by 3.7 per cent in 2025.
This would be clear progress on last year, when wages increased 5.3 per cent, but also right at the top end of the Bank’s expected range of two-to-four per cent.
It justifies the “gradual” approach to lowering interest rates that many policymakers have been talking about.
Bank of England’s scenarios
For a few months now the Bank has been outlining three potential scenarios for the inflationary outlook in the UK.
In the first, inflation returns to the two per cent target as the succession of supply shocks which hit the economy post-pandemic unwind. This is the most benign outcome and requires little contribution from monetary policy.
A middle scenario suggests that interest rates need to weigh on economic activity for a time to securely anchor inflation back at target, but it is also largely a story about supply shocks unwinding.
However, there’s also a more pessimistic outcome in which wage and price-setting behaviour in the economy have fundamentally changed since the pandemic, requiring a more forceful monetary policy response.
The Bank of England said it was placing “greater weight” on the second and third cases, which implies a more active role for monetary policy.
The Bank is clearly far more nervous about inflation than many in the City.