BoE: determined to cut despite high inflation

A divided committee: The Bank of England delivered a 25bp cut as expected today, but the two dissents in favour of a larger 50bp reduction and particularly tortured set of minutes showed that the Monetary Policy Committee (MPC) is deeply divided. The minutes described four differing views of the outlook for the economy rather than the usual two, making the future path of interest rates particularly uncertain. The MPC amended its guidance that it would take a “gradual approach” to future rate cuts to a “gradual and careful approach”. Some members probably interpret “careful” as meaning that faster cuts may be needed, and others that they could have to stop, so it adds little insight. On balance we think the Committee’s default pace of rate cuts remains 25bp per quarter – and that reasonable domestic demand and high inflation will mean the BoE will only cuts once more in May.

New forecasts illustrate the problem: The new Bank of England forecast is below consensus on growth and much higher than the consensus on inflation, highlighting the difficult balance the MPC has in striking a balance between strong near-term inflationary pressure and weak growth (see Table 1). High inflation despite weak growth partly reflects the new judgement that the supply capacity of the economy has weakened, and partly higher energy price futures. The MPC avoided mentioning the elephant in the room that will push up inflation in the minutes – the increase in payroll tax and the minimum wage on 1 April. However, the BoE staff did cover it in the Monetary Policy Report, finding that the minimum wage is preventing companies in consumer-facing sectors from responding to the hike in payroll tax by restraining pay, and forcing them to raise prices instead. As a result, services prices will continue to rise by close to 5.0% yoy until mid-2025 in the BoE’s projection, which is also a major factor behind the higher inflation forecast.

Demand or supply? The divide on the committee about the correct response to flatlining GDP, falling employment and a resurgence in inflation boils down to a difference of opinion about what is causing it. The most dovish members believe the adverse development is due to a deterioration in demand caused by weak sentiment. In their view, the BoE needs to cut interest rates faster to prevent a loosening in the labour market that means inflation falls below target in the medium term. But the most hawkish faction of the committee thinks that supply has weakened meaning that, despite weak growth, there is little slack in the economy. As a result, they are more cautious about lowering interest rates.

Mixed messages on the terminal interest rate: Inflation does not return to 2% until the end of 2027 in the new forecast, later than normal and a sign that interest rates are too low. Moreover, the forecast is based on interest rates being cut to a terminal rate of 4.00% whereas the market is now pricing in 3.75%. Therefore, if the BoE re-ran its models today inflation would not get down to target at all in the next three years. In conflict with the forecast, the Bank updated its estimate for the neutral interest rate to a range of between 2.25% and 3.75%. As well as being divided on the appropriate near-term path of bank rate, the MPC has little idea what the end destination is either.

Berenberg view: The risk to our forecast of just one more interest rate cut in May is that the BoE goes further (see Chart 1). However, we remain convinced that the BoE will have to stop cutting interest rates earlier than most expect amid strengthening inflation. We have been here before: Just over a year ago investors priced in a fall in bank rate to 3.25% by end-2025. The resulting drop in fixed interest rates available to companies and households helped drive a pick-up in GDP and pay growth that delayed the first cut until August. A boost to demand from rate cuts at the same time as firms are facing a large increase in costs that they are keen to pass on will push up inflation to well over 3% yoy in the second half of the year. The BoE will find it difficult to justify further loosening in that environment.

Table: BoE, Berenberg and consensus economic forecasts

GDP and CPI inflation in % yoy. Unemployment rate in %. Sources: BoE, Bloomberg, Berenberg.

Andrew Wishart

Senior UK Economist

+44 20 3753 3017

andrew.wishart@berenberg.com

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