Is the “New Great Inflation” over? (And if so: what happens next?)
14 August 2024
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Trade, Development, and Immigration
13 August 2024
Monetary Policy
The Bank of England’s (BoE) decision on 1 August to cut interest rates by 25 basis points, reducing Bank Rate from a 16-year high of 5.25% to 5%, has ignited a critical debate: is this the beginning of a broader move toward normalising rates at lower levels? The Monetary Policy Committee (MPC) was narrowly divided, with a 5-4 vote, hinting at a potential shift in the BoE’s stance. Yet, uncertainty looms as the Bank weighs the risks of acting too quickly or too slowly.
Under its inflation-targeting framework, the BoE’s monetary policy is inherently forward-looking, anchored by a mandate to maintain inflation at a government-set target of 2%. The Bank adjusts Bank Rate to influence market interest rates and aggregate demand, aligning actual inflation with this target. This process relies on households and firms forming rational expectations about inflation – expectations the BoE shapes through its actions and communications. Reducing uncertainty about future prices has been a cornerstone of the Bank’s credibility since it gained operational independence to set policy rates in 1997.
The sharp decline in inflation from a 40-year high of just over 11% in October 2022 suggests that the BoE’s tightening cycle may have finally tamed runaway prices. By May, the Consumer Price Index (CPI), the official measure of price stability, had dropped back to 2%, where it remained in June – marking the lowest level in three years. However, data released today shows CPI rising to 2.2% in July, marking the first upward move since December 2023, although still below forecasts. Core inflation, which excludes volatile food and energy costs, and is closely watched by the Bank, fell to 3.3% from 3.5% in June.
The current 5% overnight policy rate remains significantly higher than the pre-pandemic 0.75% (and current long-term market rates around 4%), reflecting the Bank’s cautious and restrictive stance amid lingering inflationary risks. While the BoE projects a slight uptick in inflation to 2.75% later this year, its forecasts for 2026 and 2027 – 2% and 1.8%, respectively – point to a gradual return to stability. This trajectory underscores the potential need for further rate cuts at the MPC’s 19 September meeting and at the two remaining meetings before year-end.
It’s important to note that interest rate changes do not immediately impact on the real economy. Monetary policy operates with “long and variable lags,” particularly in its effects on output and inflation. It can take several quarters for a rate cut to fully influence consumer spending, business investment, and overall economic activity. This delay complicates the timing of the BoE’s decisions. The MPC traditionally follows a data-dependent approach, but this gradualism could backfire. Delaying further cuts might necessitate drastic actions in 2025 if economic conditions deteriorate (at home or abroad) – a scenario the BoE is keen to avoid.
The BoE’s cautious approach must also contend with market expectations. While financial markets do not dictate policy, they significantly influence the economic landscape. Markets are already pricing in two additional 0.25% rate cuts before year-end, which would lower Bank rate to 4.5%. Failure to meet these expectations could lead to increased volatility and instability in both financial markets and the broader economy. After criticism for its sluggish response to surging inflation in 2021-2022, the BoE is acutely aware of the risks of disappointing the markets. Striking the right balance between market signals and its inflation mandate has never been more pressing, with money markets currently pricing in a 37% chance of a follow-up rate cut at the next meeting.
Several key economic indicators will heavily influence the MPC’s reaction function (its decision-making process). The unemployment rate, which unexpectedly dropped to 4.2% in June, remains low by historical standards but has shown signs of softening. The slight improvement in employment last month – despite expectations of a rise to 4.5% – is noteworthy but should not alone justify pausing further rate cuts.
The Bank has been burned before by misjudging inflation’s trajectory, and the spectre of 2021 looms large. Services inflation, which fell more than expected to 5.2% in July, remains stubbornly high, driven by robust demand in a tight labour market. Wage growth, too, presents a dilemma: while it boosts consumer spending, it also fuels inflation if not accompanied by corresponding productivity gains. At 5.4% in June – nearly double the rate the BoE views as consistent with 2% inflation – the Bank must tread carefully to avoid entrenching inflationary expectations.
However, a too cautious approach could become the BoE’s Achilles heel.
The money supply, typically not a central focus of the MPC, has gained increased significance in recent discussions. To maintain stable inflation and consistent economic growth, the money supply generally needs to expand at an annual rate of 4% to 5%. Although recent figures show some improvement, the sluggish 1% annual growth rate (2.5% on a three-month annualised basis) could provide the BoE with additional room to cut rates without triggering a resurgence in inflation.
Growth projections also complicate the picture. The latest GDP forecasts suggest annual growth of around 1.5% for 2024, which seems optimistic. According to the Taylor rule – a monetary policy guideline that links interest rates to levels of inflation and economic growth – policy rates should arguably be closer to 3.5% to 4%, suggesting the BoE’s current stance may be too restrictive.
The global context adds another layer of complexity. The BoE operates in a world where the actions of the US Federal Reserve, the European Central Bank, and other major central banks have profound effects on global financial conditions. The strong US dollar, for example, has already increased import prices, complicating the BoE’s inflation fight. Any misalignment with other central banks could trigger unwanted volatility in the currency and bond markets.
The MPC is caught in a bind: act too soon, and it risks reigniting inflation; wait too long, and it could choke off an already fragile recovery. The stakes are high, and the margin of error is razor thin. As the September meeting approaches, the MPC’s deliberations will be scrutinised more than ever, with market participants, policy makers and the public all anxiously awaiting a clear signal of the Bank’s intent.
Ultimately, the challenge for the BoE is not just about setting interest rates but managing expectations – those of markets, of businesses and of households. A clear and well-communicated strategy, grounded in a realistic assessment of risks, is essential. The BoE has navigated turbulent waters before, but the road ahead may be its most treacherous yet. Will it cut rates in September? The answer lies as much in the confidence of the MPC in its own judgment as in the economic indicators themselves.
Damian Pudner is an independent economist and visiting lecturer on monetary policy and financial stability. He worked for over 25 years in the city of London at several leading investment banks and financial institutions.
Under its inflation-targeting framework, the BoE’s monetary policy is inherently forward-looking, anchored by a mandate to maintain inflation at a government-set target of 2%. The Bank adjusts Bank Rate to influence market interest rates and aggregate demand, aligning actual inflation with this target. This process relies on households and firms forming rational expectations about inflation – expectations the BoE shapes through its actions and communications. Reducing uncertainty about future prices has been a cornerstone of the Bank’s credibility since it gained operational independence to set policy rates in 1997.
The sharp decline in inflation from a 40-year high of just over 11% in October 2022 suggests that the BoE’s tightening cycle may have finally tamed runaway prices. By May, the Consumer Price Index (CPI), the official measure of price stability, had dropped back to 2%, where it remained in June – marking the lowest level in three years. However, data released today shows CPI rising to 2.2% in July, marking the first upward move since December 2023, although still below forecasts. Core inflation, which excludes volatile food and energy costs, and is closely watched by the Bank, fell to 3.3% from 3.5% in June.
The current 5% overnight policy rate remains significantly higher than the pre-pandemic 0.75% (and current long-term market rates around 4%), reflecting the Bank’s cautious and restrictive stance amid lingering inflationary risks. While the BoE projects a slight uptick in inflation to 2.75% later this year, its forecasts for 2026 and 2027 – 2% and 1.8%, respectively – point to a gradual return to stability. This trajectory underscores the potential need for further rate cuts at the MPC’s 19 September meeting and at the two remaining meetings before year-end.
It’s important to note that interest rate changes do not immediately impact on the real economy. Monetary policy operates with “long and variable lags,” particularly in its effects on output and inflation. It can take several quarters for a rate cut to fully influence consumer spending, business investment, and overall economic activity. This delay complicates the timing of the BoE’s decisions. The MPC traditionally follows a data-dependent approach, but this gradualism could backfire. Delaying further cuts might necessitate drastic actions in 2025 if economic conditions deteriorate (at home or abroad) – a scenario the BoE is keen to avoid.
The BoE’s cautious approach must also contend with market expectations. While financial markets do not dictate policy, they significantly influence the economic landscape. Markets are already pricing in two additional 0.25% rate cuts before year-end, which would lower Bank rate to 4.5%. Failure to meet these expectations could lead to increased volatility and instability in both financial markets and the broader economy. After criticism for its sluggish response to surging inflation in 2021-2022, the BoE is acutely aware of the risks of disappointing the markets. Striking the right balance between market signals and its inflation mandate has never been more pressing, with money markets currently pricing in a 37% chance of a follow-up rate cut at the next meeting.
Several key economic indicators will heavily influence the MPC’s reaction function (its decision-making process). The unemployment rate, which unexpectedly dropped to 4.2% in June, remains low by historical standards but has shown signs of softening. The slight improvement in employment last month – despite expectations of a rise to 4.5% – is noteworthy but should not alone justify pausing further rate cuts.
The Bank has been burned before by misjudging inflation’s trajectory, and the spectre of 2021 looms large. Services inflation, which fell more than expected to 5.2% in July, remains stubbornly high, driven by robust demand in a tight labour market. Wage growth, too, presents a dilemma: while it boosts consumer spending, it also fuels inflation if not accompanied by corresponding productivity gains. At 5.4% in June – nearly double the rate the BoE views as consistent with 2% inflation – the Bank must tread carefully to avoid entrenching inflationary expectations.
However, a too cautious approach could become the BoE’s Achilles heel.
The money supply, typically not a central focus of the MPC, has gained increased significance in recent discussions. To maintain stable inflation and consistent economic growth, the money supply generally needs to expand at an annual rate of 4% to 5%. Although recent figures show some improvement, the sluggish 1% annual growth rate (2.5% on a three-month annualised basis) could provide the BoE with additional room to cut rates without triggering a resurgence in inflation.
Growth projections also complicate the picture. The latest GDP forecasts suggest annual growth of around 1.5% for 2024, which seems optimistic. According to the Taylor rule – a monetary policy guideline that links interest rates to levels of inflation and economic growth – policy rates should arguably be closer to 3.5% to 4%, suggesting the BoE’s current stance may be too restrictive.
The global context adds another layer of complexity. The BoE operates in a world where the actions of the US Federal Reserve, the European Central Bank, and other major central banks have profound effects on global financial conditions. The strong US dollar, for example, has already increased import prices, complicating the BoE’s inflation fight. Any misalignment with other central banks could trigger unwanted volatility in the currency and bond markets.
The MPC is caught in a bind: act too soon, and it risks reigniting inflation; wait too long, and it could choke off an already fragile recovery. The stakes are high, and the margin of error is razor thin. As the September meeting approaches, the MPC’s deliberations will be scrutinised more than ever, with market participants, policy makers and the public all anxiously awaiting a clear signal of the Bank’s intent.
Ultimately, the challenge for the BoE is not just about setting interest rates but managing expectations – those of markets, of businesses and of households. A clear and well-communicated strategy, grounded in a realistic assessment of risks, is essential. The BoE has navigated turbulent waters before, but the road ahead may be its most treacherous yet. Will it cut rates in September? The answer lies as much in the confidence of the MPC in its own judgment as in the economic indicators themselves.
Damian Pudner is an independent economist and visiting lecturer on monetary policy and financial stability. He worked for over 25 years in the city of London at several leading investment banks and financial institutions.
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