There are several technical terms used in this blog, as it’s challenging to write something like this without recourse to technical language.
Here are definitions of some technical terms to refer back to when reading this blog.
Core inflation – This refers to inflation measures that exclude volatile components like food and energy prices. Core inflation aims to capture underlying inflation trends by removing short-term noise. Common core inflation measures are CPIH (which excludes housing costs) and ‘trimmed means’ inflation (which removes outliers).
Inflation expectations – This refers to what households, businesses and investors expect inflation rates to be in the future, usually over the next few years. It is measured via surveys asking people’s inflation forecasts or by market indicators like the difference between nominal and inflation-linked bond yields. Anchoring expectations is crucial for monetary policy credibility.
Monetary policy refers to the actions taken by a country’s central bank to influence the availability and cost of money and credit in the economy, with the goal of promoting economic growth and stability. The main tools used to implement monetary policy are adjusting short-term interest rates and controlling the money supply
Purchasing Managers Index (PMI) – PMIs are monthly survey data of business conditions and sentiment in sectors like manufacturing, construction and services. PMIs over 50 indicate economic expansion while below 50 signals contraction. The surveys provide timely leading indicators for official GDP estimates.
Gross Domestic Product (GDP) – GDP measures the total value of goods and services produced in an economy. It is the broadest measure of economic growth or recession (defined as two consecutive quarters of negative GDP). The BoE monitors GDP growth trends closely.
Housing markets – The BoE keeps a close watch on the housing market given its importance for household wealth and consumer spending. Metrics like property prices, housing starts, mortgage lending activity, and construction PMIs help assess housing market conditions relevant for rate decisions.
Currency depreciation – This refers to a currency declining in value against other currencies. It is a risk if interest rate differentials between countries spur capital outflows, weakening demand for the currency. Currency depreciation contributes to higher imported inflation.
When Will Interest Rates Finally Come Down in the UK?
Interest rates have been on the rise in the UK as the Bank of England (BoE) has steadily increased its base rate in recent months to combat surging inflation. However, with economic growth slowing and fears of a recession growing, many are wondering when the BoE will reverse course and start cutting rates to provide stimulus to the economy. In this post, we’ll explore the key factors that could influence when interest rates finally start dropping again in the UK.
Taming Inflation is Key
The BoE’s main objective is to keep inflation low and stable around the 2% target. High inflation – driven by factors like supply chain snarls, labour shortages, and elevated energy and food costs – is the primary reason the central bank has hiked rates. For the BoE to consider rate cuts, it will want to see clear evidence that inflation is on a downward trajectory back towards the 2% level in a sustainable way.
Core inflation measures that exclude volatile food and energy prices will be a key gauge. Metrics like CPIH, which removes housing costs, or “trimmed means” inflation that strips out outliers can indicate if underlying price pressures are abating. If core inflation comes down steadily over several months, it signals broad disinflation beyond just temporary fluctuations in commodity prices. The BoE will want to see inflation clearly moving down on a 12-18 month horizon before getting comfortable cutting.
Anchoring inflation expectations will also be crucial – if households and businesses expect inflation to moderate over the next 1-2 years, they may reduce demands for high wage and price increases, helping lower actual inflation. The BoE will monitor surveys of inflation expectations and market-based measures like breakeven inflation rates (the difference between yields on nominal and inflation-linked bonds). If expectations remain stubbornly high, the BoE may refrain from rate cuts even if actual inflation edges down.
Watching for Economic Slowdown Signals
The BoE monitors a broad suite of economic data, looking for signs of slowing growth or recession risk. Early warning indicators include declining Purchasing Managers Index (PMI) survey data, falling business investment intentions, job hiring starting to freeze up, and worsening consumer confidence. These “soft data” often front-run “hard data” like GDP, retail sales, and unemployment, which tend to lag behind in recessions.
If both soft and hard data deteriorate substantially over several months, it would likely prompt rate cuts to support growth. The depth of the downturn will influence the magnitude of rate decreases – a shallow recession may just pause hikes, while a severe slump could spur 50 basis point or larger cuts at consecutive meetings. Housing market metrics like property prices, mortgage lending, and construction activity are also important barometers the BoE watches closely when setting interest rates.
Global Policy Spillovers
The BoE does not make policy decisions in a vacuum. It has to consider the actions of other major central banks like the Federal Reserve, European Central Bank, etc. If the Fed pivots to rate cuts, for example, the BoE would need to consider the policy rate differential and implications for capital flows and the pound.
Too big a gap between Fed and BoE rates could spark destabilising capital outflows from the UK and lead to currency depreciation, which raises imported inflation. That limits the BoE’s room to manoeuvre. It may follow the Fed’s lead in cutting rates if growth is weak globally to avoid too much currency depreciation. In a synchronised global recession, coordinated rate cuts across major economies have bigger impact – as happened during the 2008 financial crisis. But outside dire situations, policy alignment is harder. The BoE will keep a close eye on signals from the Fed and ECB as it weighs potential rate cuts.
Brexit Uncertainty Still Looms
The final shape of the UK’s new trading relationship with the EU remains uncertain despite formally leaving over two years ago. Ongoing Brexit uncertainty has already dampened business investment in the UK. It risks being an ongoing drag on productivity and growth if firms continue delaying major investments and expansion plans.
New frictions in trade flows with the EU resulting from Brexit could also undermine competitiveness over time if not resolved. Additionally, changes to immigration policy will shape the UK’s access to labour and skills in key sectors like healthcare, retail, and construction. Shortages of workers and skill mismatches are a headwind for economic activity. Rate cuts could provide some stimulus, but likely not fully offset Brexit-related structurally slower productivity and growth.
UK Outlook Hinges on Global Forces Too
While Brexit is important for UK economic prospects, global factors outside of the BoE’s control also loom large. The path of the pandemic, supply chain normalisation, Ukraine war fallout, and Chinese growth outlook could all influence UK inflation and growth. If global factors drive further inflation shocks without boosting growth, it limits the BoE’s scope to cut rates. However, a positive resolution of supply issues and commodity price pressures could relieve constraints on monetary policy.
Shifting Views Among Policymakers
Opinions differ within the BoE’s Monetary Policy Committee (MPC) on how quickly inflation will fall back to target and how vulnerable the economy is to recession. External MPC members like Michael Saunders and Catherine Mann have signalled more hawkish views on inflation risks versus internal members. If enough of them shift to prioritising downside growth risks, it could swing the overall MPC stance toward rate cuts.
Personnel changes matter too – the departure of historically more hawkish members like Andy Haldane has tilted the MPC’s composition slightly more dovish on average. The new BoE Governor succeeding Andrew Bailey next year will also be key in shaping consensus. Tracking dissenting votes, policymaker speeches, and leadership transitions can provide valuable signals on whether the BoE’s thinking is tilting dovish.
Path Dependent on Data
The BoE has emphasised that monetary policy will be data-dependent going forward. If hard data on inflation, consumption, investment and jobs evolves differently than the BoE expects, it will adjust course accordingly. Policymakers will have to weigh risks between tightening too much and slow growth versus cutting too early and sparking inflation. Noise in data from volatile categories like energy costs will make interpreting trends difficult. Clear downward shifts across a range of metrics would be needed before the BoE opens the door to rate cuts. But if the data breaks the right way, cuts could come sooner than 2024.
The Road Ahead
Given still high inflation and economic uncertainty, rate hikes are likely not over yet in the UK. But further out in 2023 or 2024, if inflation keeps descending, growth faltering, and global central banks cutting rates, the BoE could switch to rate cuts to provide economic stimulus. The timing and magnitude will depend on how inflation metrics evolve relative to growth and unemployment data. For now, the BoE is firmly in watch-and-wait mode, but the winds may shift to easier monetary policy sooner than many expect if trends align.
