The Bank of England’s decision to cut UK interest rates to 5% this week was finely balanced but surely correct. The aim now should be to return rates to a ‘neutral’ level of around 4% early next year.
The obvious starting point is that CPI inflation has now been at or very close to the MPC’s 2% target for three successive months. This was perhaps a necessary but not sufficient condition for a rate cut.
More importantly, the Bank’s own forecasts point the way. Inflation is expected to pick up temporarily in the second half of this year, but then be back at or below the 2% target over the medium term even on the basis of market expectations that rates will be cut to 4¼% in one year and 3½% in two.
In the meantime, the economy has been a little stronger than expected. Indeed, Bank staff have now pencilled in UK GDP growth of 0.7% q/q in Q2, the same as Q1. They then forecast a slowdown to 0.4% in Q3 and 0.2% in Q4, but with risks skewed to the upside.
Overall, this would be consistent with annual growth of about 1¼% for 2024, up from the Bank’s previous estimate of ½%. (This number compares the average level of GDP across the whole of 2024 with the average for 2023. The figure for Q4 2024 compared to Q4 2023 would be about 2%.)
Nonetheless, this better performance is partly based on hopes that falling inflation will be followed by falling rates. I therefore think that the Bank needed to deliver a rate cut to sustain the recovery in business and consumer confidence. In other words, I’d see the Bank’s forecasts as internally consistent: lower inflation, lower but still restrictive interest rates, faster but still so-so growth.
Crucially, even at 5%, interest rates are well above the ‘neutral’ level and therefore will continue to bear down on inflation (especially as the Bank is persisting with ‘quantitative tightening’ as well). This ‘neutral’ level is perhaps 4% for nominal rates, based on 2% inflation and 2% real economic growth.
The fact that monetary policy is still restrictive is half of the answer to those saying ‘what about services inflation’? This is indeed still well above 2% (stuck at 5.7% in May and June). The other half is that leading indicators of inflation point to easing price pressures in the services sector (including expectations for wages and for inflation itself).
When will the Bank of England cut again? If I were on the MPC I would keep going – ¼ point cuts at the remaining three meetings in September, November and December, taking rates from the current 5% to 4¼% by year-end, then to 4% in early 2025.
But the hawkish tone of the minutes, and the cautious comments from the Governor, suggest they might move more slowly (mirroring the ECB, which has also paused after a first cut back in June as euro area inflation has edged up again to 2.6%, roughly where the Bank this it is heading in the UK).
In particular, waiting until November would allow the MPC to assess the next set of economic forecasts in the quarterly Monetary Policy Report. This would also allow the MPC to digest the October Budget (on October 30th) and find out how the above-inflation public sector pay awards will be financed (i.e. how big the tax hikes will be). An alternative scenario might therefore see just one or two more cuts this year, to 4½- 4¾%, though we should still get to 4% in 2025.
ps. on those public sector pay rises, my take is that whether or not they are inflationary depends on i) how they are financed, and ii) whether there are any knock-on effects on the private sector (‘wage-price spirals’). I’m relatively relaxed on both points.
On i), it’s not usually possible to charge more for public services, so pay rises cannot be financed by raising prices directly. Instead, taxes will have to go up, either now or in the future, thus offsetting any inflationary impact on the demand side. So (unless the pay rises are financed by printing money), this could all come out in the wash.
On ii), public sector pay rises are (arguably) just catching up with those in the private sector (albeit without the same gains in productivity). Looking forward, almost all the survey evidence suggests that private sector pay rises are still likely to slow over the coming year(s).
You could also argue that public sector pay rises that ease problems of recruitment and retention are good for the supply side of the economy (e.g. cutting NHS waiting lists and making it easy for other people to go back to work). However, I’d balance that against the adverse impact of higher taxes on savings and investment.
In short, I don’t think these public sector pay rises are a good enough reason not to cut rates again soon, but the risks of knock-on effects may still play into the MPC’s thinking.
pps. I’m not much into MPC ‘Kremlinology’ either, but interesting that ex-Treasury and OECD Chief Economist Clare Lombardelli voted for a cut at her first meeting and that this tipped the balance (though her predecessor, Ben Broadbent, might have voted for a cut anyway).
Some had speculated that Lombardelli might want to sit tight until she found her feet. However, she had attended plenty of MPC meetings before (as the Treasury observer), and the OECD had broadly supported monetary easing.
Moreover, the markets were expecting a cut today – and the Governor voted for one – so this was arguably the ‘neutral’ position to take. Either way, fair play to her!
Plain-speaking Economics 