The Bank of England’s decision to cut interest rates by 25 basis points last week was widely anticipated, but it still stunned some economists. That’s because Catherine Mann, the Monetary Policy Committee’s arch-hawk, suddenly switched from calling for the cost of credit to stay where it is, to voting for a jumbo half-point cut. Her argument, outlined in an interview in the Financial Times on Tuesday, was that Britain’s economic outlook had weakened substantively, putting rate-setters on the back foot. As things stand, she is not wrong.
At 4.5 per cent, the bank rate is well above most estimates of the so-called neutral rate, the point at which monetary policy is neither expansionary nor contractionary. Inflation is close to target, at 2.5 per cent, and with the UK economy treading water, weak demand should keep a lid on further price pressures.
On Thursday, data from the Office for National Statistics is expected to show that the UK economy barely grew in the second half of 2024. Business and consumer confidence has wilted since the Labour party took charge last summer. The chancellor Rachel Reeves’ decision to raise employers’ national insurance contributions in the Autumn Budget has pushed up companies’ costs and triggered a slowdown in hiring. A survey on Monday showed UK recruiters were reporting the toughest conditions in the jobs market since the Covid-19 pandemic. Weak economic activity tends to make it harder for businesses to pass on higher costs to consumers, restraining inflation.
This all suggests current interest rates are too restrictive. Financial markets are pricing in around three further 25bp cuts before the end of the year. But, given sluggish economic activity, the BoE may need to go further, faster. Indeed, with most UK mortgages agreed at a fixed rate, it will take time for any rate cuts to improve consumers’ cash flow.
There are reasons for caution, though. First, the BoE’s latest inflation forecasts showed price growth actually rising in the near term. A number of price shocks, including from higher energy prices and the NICs increase — which will take effect in April — are expected to push UK inflation up to 3.7 per cent later this year. Though central banks often look through temporary bumps in prices, there is a risk that this one becomes entrenched particularly as inflation has been above target for so long. Businesses could react to a range of higher costs by pushing up retail prices. If so, Britain could face a nasty dose of stagflation.
Second, economic uncertainty is high. It is unclear what impact trade wars might have on the UK economy. The ONS’ labour market data is also currently unreliable, due to falling response rates to its surveys. Together, these factors make it harder for the BoE to judge how much of the economic slowdown is driven by falling demand or supply.
This strengthens the case for proceeding with gradual rate cuts, in quarter-point steps, and then accelerating cuts should this year’s inflation rise indeed prove to be temporary. Central banking is about balancing risks, and though the case for cutting rates faster now is strong, gradualism gives the BoE more flexibility when economic clarity is particularly lacking. Mann’s diagnosis is right, but her choice of medicine, a chunky 50bp cut, would not be prudent at this point.
More importantly, though lower rates would prop up Britain’s sagging economy — and reduce government borrowing costs — it would only soften the symptoms of a deeper malaise. The onus remains on Labour, not the BoE, to reignite animal spirits and outline a fiscally credible path to higher long-term growth.