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Unexpected strength in UK services inflation has left the Bank of England’s meeting on Thursday on a knife edge, as policymakers weigh whether to push ahead with the first reduction in interest rates since 2020.
With headline inflation sitting at the 2 per cent target for two successive months, the Monetary Policy Committee has an opening to deliver a quarter-point interest rate cut to 5 per cent — something BoE governor Andrew Bailey has been suggesting since March is on the cards this year.
However, policymakers have been wavering because services inflation — a key gauge of domestic pricing pressures — has repeatedly overshot BoE forecasts. Huw Pill, BoE chief economist, warned this month that the main drivers of UK inflation were showing “uncomfortable strength”.
“The data doesn’t provide clear signals that inflation persistence is beaten,” said Sonali Punhani, UK economist at Bank of American Merrill Lynch.
Nevertheless, she added, the BoE could be willing to “tolerate and explain away” stronger-than-expected price growth and go ahead with a cut, “especially in the context of UK inflation rising again later in the year, which could make the communication around future cuts more difficult”.
Bailey has been dangling the prospect of lower interest rates since early this year and two members, deputy governor Dave Ramsden and external MPC member Swati Dhingra, have already started voting for reductions.
The European Central Bank and Bank of Canada are among fellow banks that have already started lowering borrowing costs. The US Federal Reserve is expected to consider a move in September.
To date, the majority of the MPC has opted to stick at 5.25 per cent — the level reached in August of last year.
The problem has been the slow downward progress of services inflation — an indicator that is central to the BoE’s assessment of whether it has won the war on price growth. In June services prices grew 0.6 percentage point more than the BoE predicted, leaving the annual growth rate at 5.7 per cent.
While headline inflation is on target, it is widely expected to start increasing later this year because of rising energy prices.
On the other hand, wage growth has eased somewhat, pointing to a loosening labour market. Average earnings growth slowed to 5.7 per cent in the March-to-May period from 5.9 per cent, while job vacancies have fallen and unemployment at 4.4 per cent is a little higher than the BoE expected.
“Even if the data themselves are not unequivocally weaker, we would argue that at some point the MPC must come to the judgment that enough time has passed with restrictive rates that the start of the cutting cycle can be justified. We think that time is now,” wrote George Buckley, chief European economist at Nomura, in a note.
Critical to the outcome of the meeting this week is whether Bailey himself decides that it is an opportune moment for a cut. He is likely to have been among those at the BoE’s last meeting who considered the decision to keep rates unchanged “finely balanced”, suggesting he thought the case for a reduction was nearly made.
Markets will be watching closely to see how the new deputy governor Clare Lombardelli, who succeeded Ben Broadbent, votes at her first meeting. Pill will also be a key MPC member to watch: his comments on sticky services prices suggest that he will be wary of jumping the gun.
Among the most likely opponents to a reduction are external members Jonathan Haskel and Catherine Mann. This will be Haskel’s last meeting on the MPC, and the absence of an announcement on his replacement raises the possibility that the committee will be down a member when it next meets in September.
“If rates are lowered in August, it looks likely to happen on a close 5-4 vote,” said Allan Monks at JPMorgan. “A cut would feel like it’s coming despite, rather than because of, data developments since May.”
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