The Bank of England’s decision to trim its key interest rate by another quarter point this week was widely expected, but there is still plenty to write about. Unfortunately, little of this is good news.
For a start, why on earth is the Monetary Policy Committee (MPC) still cutting rates when the Bank itself now expects CPI inflation to rise further, peaking at 4.0pc in September? This would be double the MPC’s 2.0pc target, which is meant to be met “at all times”.
That is a reasonable question. Indeed, the MPC only voted by the slimmest of margins to cut, with four of the nine members preferring to leave interest rates on hold. (This was only partly offset by the fact that one member, the relatively ‘dovish’ Alan Taylor, would have liked to cut by a half point if that option had been put to a vote.)
This ambivalence has worried the bond markets – the UK Government’s cost of borrowing actually rose on the news. The mortgage markets may also react badly to concerns that inflation will remain higher for longer, delaying any further cuts.
Fortunately, the MPC’s mandate provides some flexibility. The mandate allows the target to be overshot temporarily if there are good reasons to expect inflation to drop back to target soon, and if the costs of correcting the overshoot more quickly – in terms of lost output and jobs – would otherwise be too great.
The recent pick-up in inflation partly reflects global factors which are outside the Bank’s control. These include the impacts of higher prices for energy and agricultural commodities, which should drop out of the headline inflation rate next year.
Nonetheless, the gap between inflation in the UK and the rest of Europe has widened noticeably since last October’s Budget. Despite the same global pressures, inflation in the euro area has settled at around 2pc.
The obvious culprit is the continued pass through of higher payroll costs following the large increases in employers’ National Insurance contributions and in minimum wages.
It was always likely that these policy choices would backfire on “working people”, both by raising prices and by hitting jobs. But they have made the MPC’s task much more difficult too.
Despite this, there are some good reasons to expect the jump in underlying inflation – excluding the impact of higher food and energy prices – to be temporary as well. In particular, the labour market is now cooling rapidly, meaning the risks of further wage-led inflation is much lower. Surveys of inflation expectations (including the Bank’s own Decision Maker Panel) are mixed, but mostly reassuring.
Moreover, unlike in the post-Covid period when inflation was much stickier than most had expected, the money supply is now under control. In part this is due to the MPC’s decision to keep monetary policy tight by selling government bonds, reversing the previous policy of ‘Quantitative Easing’.
Though few will pay much notice, the Bank’s preferred measure of broad money (known as M4) is growing at an annualised rate of just 3pc. That is unlikely to be enough to sustain inflation much above 2pc, unless the UK economy is heading for a prolonged slump.
Alas, the risks to economic activity are skewed to the downside. The immediate threat of a devastating global trade war has faded, but US tariffs will still be substantially higher than a year ago. At home, business and consumer confidence are already stuttering again as another punitive Budget looms in the Autumn.
This has two implications. First, and in my view, it makes perfect sense to return interest rates towards a more neutral level, rather than keep them higher to cap a rise in inflation that is likely to be temporary anyway.
Even at the new level of 4pc, interest rates are (just about) restrictive enough to continue to bear down on inflation, especially with the Bank also persisting with ‘Quantitative Tightening’. Indeed, the financial markets still expect the MPC to be forced to ease further, with rates bottoming out at around 3.5pc next year. However, this is already factored in to the OBR’s forecasts for the public finances.
For what it is worth, I continue to expect the MPC to cut once more this year, in November (alongside the next set of quarterly forecasts, and following a very tight Budget), then perhaps once more in early 2026 (taking rates to the mid-point of what might be thought of as a ‘neutral’ range of 3-4pc).
Second, though, the Government cannot take any credit for the Bank of England’s decisions. The MPC has now delivered five interest rate cuts since last July’s election. But the European Central Bank (ECB) has cut its key interest rate seven times over the same period, to just 2pc, and eight in total since the peak.
The bottom line is that UK official interest rates are still higher than they would have been if UK inflation were not such an outlier. What’s more, the interest rates that really matter – mortgage rates and government bond yields – are either little changed, or higher.
Above all, the MPC only cut this week because the slimmest of majorities thought the risk of recession outweighed the reality of rising inflation! This is nothing much to cheer.
This is an extended version of a piece first published by the Daily Telegraph on 7 August 2025
Plain-speaking Economics 