The Monetary Policy Committee’s decision to leave interest rates on hold at 5.25% this week was unsurprising, but there were some welcome hints that cuts are coming soon.
The market reaction was consistent with the slight dovish tilt: 2-5 year government bond yields fell about 5 basis points (these correlate closely with the cost of 2-5 year fixed rate mortgages), the FTSE rose about 1.5%, and pound fell about 1% against the US dollar.
Indeed, the latest news on UK inflation has been reassuring. The renewed slowdown in the headline rate to 3.4% in February paves the way for CPI inflation to dip below the 2% target in April when the new Ofgem cap on energy bills kicks in. A figure as low as 1.5% is plausible.
This would not necessarily be enough to justify a rate cut – the MPC will want to be sure that any return to the 2% inflation target is sustainable. But it would be a huge improvement on what the Bank had been expecting as recently as last November, when the Monetary Policy Report had assumed that inflation would not return to 2% until the final quarter of 2025!
In reality, the consumer price index has been little changed (in level terms) since September, meaning that shorter-term measures of inflation are already close to zero. This is consistent with the sharp slowdown in the growth of money and credit too.
Some underlying measures are still high, notably annual services inflation which is running at 6.1%. But with plenty of evidence that the labour market is cooling, and with inflation expectations also dropping, fears of a ‘wage-price spiral’ should fade too.
This new evidence was reflected in Thursday’s announcement.
For a start, the two MPC members (Jonathan Haskel and Catherine Mann) who had still been voting for another hike both switched to ‘no change’ at this meeting. The debate is now about when rates will be cut, not if.
Eight of the nine members still need more evidence before joining Swati Dhingra in voting for a cut, but only four of them have to do so for the vote to swing 5-4 in favour of lower rates.
The accompanying statement also suggested that the rest of the MPC is becoming more confident that underlying inflation is moving in the right direction.
There were the usual warnings about upside risks, notably from the crisis in the Middle East. But there is still little evidence that Red Sea disruption is having any major impact. For example, the latest trading statement from Next played down the impact on stock levels, with the retailer still expecting to cut prices later in the year despite higher freight costs.
The Bank also flagged up the business survey evidence that the technical ‘recession’ is already over. This was reinforced this morning by the flash PMIs for March. At the margin, these signs of recovery perhaps make it easier to delay a rate cut, but the big picture is that growth is still anaemic.
The MPC did at least give a pass to the Spring Budget, noting that the limited fiscal stimulus is not a major risk to inflation.
The upshot is that the MPC is now ready to cut interest rates once it has more evidence that underlying #inflation pressures are fading, with a particular focus on the labour market and services.
I have not given up on a first move at the next MPC meeting in May, when the Bank’s latest Monetary Policy Report is published. If inflation is forecast to remain at or below the 2% target for an extended period, even based on market expectations of big cuts in interest rates, then it will be hard for the Bank to keep rates on hold.
However, the most likely date for the first reduction is probably June. The Bank will then have the April inflation data and a lot more information on the labour market and price pressures in the services sector.
As it happens, June is the most likely month for the Fed and ECB to cut rates too, though this would not prevent the Bank of England from moving sooner if justified by the outlook for UK inflation. The Swiss National Bank has already cut rates without waiting for others, albeit after a much longer run of better inflation data
But whatever the precise timing, the first UK rate cut is likely to be just the first in an extended series. I have suggested before that the base rate will be back to 4% by the end of this year, and am still confident in that call.
Further cuts are then possible in 2025, perhaps to as low as 3%. However, the ‘new normal; is hopefully about 4% – a level consistent with inflation of around 2% and real economic growth of around 2%, which would be an ideal place to end up.
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