- US Federal Reserve and Bank of England expected to hold rates in the first meetings of the year
- But could we see March rate cuts?
Inflation is heading downwards and rate cuts should soon be in sight. But when the Bank of England (BoE) makes its move will have a big impact on investors and stock markets.
The latest messaging from the BoE’s Monetary Policy Committee (MPC) has been hawkish, however. After December’s meeting, rate-setters warned that “monetary policy will need to be sufficiently restrictive for sufficiently long” to return inflation to the 2 per cent target. Of the nine MPC members, six voted to hold rates at 5.25 per cent, while three voted for a further 0.25 percentage point hike, as the chart below shows.
But since then, a lot has changed. The latest inflation data was hotter than markets anticipated, but far lower than the BoE’s models had forecast. As a result, expectations for the timing of the first UK rate cut have whipsawed: traders rushed to place their bets on May – before moving them back to June.
There is no realistic prospect of the MPC voting to cut rates in its 1 February meeting, although there are still hopes that we could see the first rate cut sometime in the spring. These are the signs investors should look for that a policy pivot is on the cards.
Inflation falls to 2 per cent
Inflation is falling back towards target – but the path back down to 2 per cent won't be smooth. Analysts at Capital Economics expect the inflation rate to tick up again in January's data, and see inflation “turbulence” continuing over the next few months. There is also a risk that supply chain disruption in the Red Sea could see goods inflation surge again. The uncertainty could ultimately encourage rate-setters to hold off.
Forecasts suggest that inflation will fall below 2 per cent in the spring – lower than the inflation target, and lower than inflation rates in the US and euro area, too. According to analysts at Capital Economics, “our forecast that inflation will fall below 2 per cent in April means they [BoE rate-setters] may change their tune by May”.
Wage growth falling below 5 per cent
But inflation figures aren’t the only metric that rate-setters are keeping an eye on. Towards the end of last year, MPC members stressed concerns about the labour market, warning that high wage growth could fuel sustained inflation.
The latest data suggests that average growth in regular pay has cooled to 6.6 per cent, lower than last month’s 7.2 per cent figure, but high enough to continue to put upward pressure on the inflation rate. Deutsche Bank senior economist Sanjay Raja thinks wage inflation of 4.5-5 per cent would be low enough for the BoE to cut rates – although only relatively cautious ones.
The economy dodges deep recession
Rate-setters are also grappling with the time tag between hiking rates and it feeding through to the economy. These are only just beginning to bite and Raja thinks some 1.75 percentage points of higher interest costs are yet to feed through. This means keeping rates at today's high levels raises the very real risk of ‘overtightening’.
If data shows that the UK economy contracted by 0.1 per cent in the last quarter of 2023, the UK would find itself in a technical (though extremely mild) recession. According to Capital’s chief UK economist, Paul Dales, this “wouldn’t change the narrative that the economy is stagnating rather than collapsing”. As a result, it might not be enough to nudge the MPC off course.
Budget spending plans crystalise
The Spring Budget and election add a layer of uncertainty to gross domestic product (GDP) forecasts. Public finance figures for December have increased expectations for tax cuts this year, with falling gilt yields and lower payments on index-linked gilts reducing the government’s debt interest costs. Analysts at Pantheon Macroeconomics think that the chancellor can use this "near-term windfall" to "cut taxes without provoking the market’s ire”.
But this could make life more difficult for the BoE. If tax cuts boost demand, inflation could reignite. Samuel Tombs, chief UK economist, warns that “large tax cuts would reduce the MPC’s scope to cut this year and the Conservatives cannot risk pushing up mortgage rates again”.
‘Two-sided’ guidance and the first rate cut vote
The very mixed economic picture will probably be reflected in the forecasts issued by the BoE next month. Last year, projections implied that it would take until the end of 2025 for inflation to return to 2 per cent, although it now looks to be far quicker. If the new projections show inflation making a swift return to target, this would signal a swifter pivot towards rate cuts, too. Given positive progress on inflation (see chart below), the BoE’s message of ‘higher for longer’ interest rates no longer rings quite true.
The monetary policy statement will offer further clues. Deutsche Bank's Raja thinks rate-setters could soon shift to ‘two-sided guidance’, issuing comments stressing that rates can be adjusted in either direction depending on the latest data releases. Even a subtle change in wording would be interpreted by markets as a signal that the door has been opened for cuts.
The first vote for an interest rate cut will also be a watershed moment. Dovish rate-setter Swati Dhingra has voted to keep rates on hold since December 2022, and could be the first to vote for a cut. But because the policy rate is determined by a vote, we might need to wait a while before others agree with her. Analysis from Capital Economics suggests that on average, the first MPC member ‘turns’ two meetings before the majority.
