BoE preview: faster cuts would make UK inflation a bigger problem

Click here for full report and disclosures

● Fending off another recession: Alongside a widely anticipated 25bp reduction in the bank rate this Thursday 6 February, the Bank of England (BoE) may hint that it could lower interest rates again in March. Until now, the BoE has cut at alternate meetings, but a stagnating economy and declining employment argue for more urgent action. The central bank judged the labour market to be broadly in balance at the 18 December meeting, before payroll data for December revealed further job losses. On that basis, it is sensible for the BoE to lower interest rates to prevent a larger drop in employment. Chart 1 shows that policymakers tend to take corrective action when surveys of employment slump.

● New forecasts will support rate cuts: The BoE’s new forecast will be based on two interest rate cuts this year (market pricing during the 15-day averaging window in late January) as opposed to four in the previous edition. This, alongside disappointing growth, will depress the GDP and inflation projections. Quarterly GDP growth was zero in Q3 and most likely in Q4 too, falling short of the BoE’s forecasts of 0.2% qoq and 0.3% qoq respectively. Therefore, we expect the BoE to revise down its GDP forecast for 2025 from 1.5% yoy to 1.0% and lower its forecast for CPI inflation for Q1 2027 from 2.1% yoy in November to about 1.7%. A forecast of below 2% inflation in two years’ time is a signal that looser policy is needed.

● Not that simple: Not all of the Monetary Policy Committee (MPC) will be on board with that message, and the most hawkish member, Catherine Mann, is likely to dissent by voting to hold the policy rate unchanged at 4.75%. Rate cuts would be uncontroversial if the current downturn were driven purely by demand – but we doubt it is. In our view, the recent fall in employment is instead primarily a consequence of an impending rise in labour costs. A further increase in the minimum wage and a hike in payroll taxes on 1 April will raise the cost of low-paid and part-time employment substantially. The MPC has so far played down the acceleration in average weekly pay growth as a volatile aberration. But our analysis shows that the compression of the bottom half of the pay distribution by increases in the minimum wage over recent years means that the policy is now exerting upward pressure on headline measures of pay growth. A big increase in costs is a supply shock, and not one that monetary policy can directly counteract.

● A one-off or a shift in inflation psychology? The dovish contingent of the committee argues that falling employment will feed into weak demand and inflation, and three of the nine members voted to cut at the last meeting in December. But the hawkish camp is unconvinced. The BoE’s own Decision Maker Panel survey shows that firms have enough pricing power to pass on much of the increase in their costs to customers in the form of higher prices. Companies’ expectations for price growth over the next year rose to 4% in December, ending a downward trend in companies’ pricing intentions. Over the course of this year, the debate will likely turn to whether this increase in prices will be (another) one-off or risks dislodging the low-inflation psychology that helped the BoE keep inflation close to 2% in the past. Survey and financial market measures of inflation expectations are not overly worrying. But that could change if supply shocks (also including tariffs and deglobalisation) cause inflation to continue to misbehave.

● Worry about inflation later: There is a risk that the BoE will reduce interest rates faster than we predict in the near term. However, we continue to think that it will have to stop lowering interest rates in the second half of the year. Neither bank lending growth nor the housing market suggest that interest rates are overly restrictive. Rising government spending and rate cuts will encourage demand and allow firms to cover higher costs by raising prices. The survey data are flagging a renewed increase in inflation – see Chart 2. As a result, we expect inflation to rise to 3.0% this year (consensus: 2.6%) and that the reduction in the bank rate from 4.75% to 4.50% on Thursday will be the penultimate cut in this cutting cycle.

Andrew Wishart

Berenberg

Senior UK Economist

andrew.wishart@berenberg.com

+44 20 3753 3017

Disclosures

This material is intended as commentary on political, economic or market conditions for institutional investors or market professionals only and does not constitute a financial analysis or a research report as defined by applicable regulation. See the "Disclaimers" section of this report.

The commentary included herein was produced by Joh. Berenberg, Gossler & Co. KG (Berenberg). For sales inquiries, please contact:

Phone: +44 (0)20 3207 7800
Email: berenberg.economics@berenberg.com

BERENBERG
Joh. Berenberg, Gossler & Co. KG
Neuer Jungfernstieg 20
20354 Hamburg
Germany

Registered Office: Hamburg, Germany
Local Court Hamburg HRA 42659

For Berenberg the protection of your data has always been a top priority. Please find information on the processing of personal data here.
Any e-mail message (including any attachment) sent by Berenberg, any of its subsidiaries or any of their employees is strictly confidential and may contain information that is privileged or exempt from disclosure under applicable law. If you have received such message(s) by mistake please notify the sender by return e-mail. We ask you to delete that message (including any attachments) thereafter from your system. Any unauthorised use or dissemination of that message in whole or in part (including any attachment) is strictly prohibited. Please also note that any legally binding representation needs to be signed by two authorised signatories. Therefore we do not send legally binding representations via e-mail. Furthermore we do not accept any legally binding representation and/or instruction(s) via e-mail. In the event of any technical difficulty with any e-mails received from us, please contact the sender or info@berenberg.com. Deutscher disclaimer.

Click here to unsubscribe from these emails.