Rate cut hopes rise after surprise inflation drop

The headline rate of UK inflation fell to 3.4 per cent in February, raising hopes of a return to the 2 per cent target  – and interest rate cuts. The figure came in slightly better than expectations and represents the lowest annual rate since September 2021. Core inflation, which strips out more volatile food and energy prices slowed to 4.5 per cent, down from 5.1 per cent last month.

According to the Office for National Statistics (ONS), housing and household services pulled the figure upwards in February, while large downward contributions came from food and non-alcoholic beverages, restaurants and hotels.

The headline rate of inflation has fallen substantially from a peak of 11.1 per cent in October 2022, hitting 4 per cent at the start of this year. Many forecasters – including the Bank of England – expect the rate of inflation to return to the 2 per cent target in the second quarter, before rising again to around 2.75 per cent later in the year. The Bank's projections suggest that inflation will be around 2.3 per cent in two years and 1.9 per cent in three.

Central bankers expected to wait for crucial April data

Rate-setters remain concerned about the ongoing persistence of ‘domestic inflationary pressures’. Though external factors like energy prices and supply chain disruptions contributed to the early inflation surge, BoE officials are now worried about the impact of UK wages and demand on the price level. 

The latest data revealed that wage growth continued to slow in the three months to January. Average earnings including bonuses were 5.6 per cent higher over the period than a year earlier – down from an annual growth rate of 5.8 per cent. But there is still a long way to go: economists calculate that wage growth needs to slow to closer to 3 per cent to be consistent with inflation returning to the 2 per cent target.

James Smith, developed markets economist at Dutch bank ING thinks that rate-setters will be keen to see April and May inflation data (published the following month) before committing to a cut. Figures for these months will reflect annual price hikes and the impact of an increase in the National Living Wage, which is set to increase by almost 10 per cent in April. According to Smith, June’s meeting will be “the earliest point for a rate cut”, though policymakers could wait until the following meeting in August. 

Expect another vote split

Before today’s inflation announcement, economists at Pantheon Macroeconomics forecast another three-way vote split in tomorrow’s meeting, with one member of the Monetary Policy Committee (MPC) voting to cut rates, two favouring a further 0.25 percentage point hike, and six favouring a hold. Sanjay Raja, UK economist at Deutsche Bank, saw scope for more consensus, expecting 8 votes to hold rates, and for one a cut. Today’s inflation release will do little to move the dial: the MPC might move from a three-way to a two-way split, but is not expected to cut interest rates yet. 

Following today’s inflation announcement, Jeremy Batstone-Carr, European strategist at wealth manager Raymond James, said that underlying price pressures should continue to ease over spring, “providing additional encouragement ahead of the Bank’s base rate decision tomorrow”. He added that though the Bank would probably want more evidence of falling inflationary pressures, there is nothing in the data to “dissuade the Monetary Policy Committee from cutting the base rate in the early summer”.