The week ahead: headwinds won’t knock MPC hawks off rate-cut path

There was always very little chance that the Bank of England (BoE) was going to cut interest rates last week, despite a slight shift in mood as three members – rather than the expected two – voted for a 25 base point (bp) reduction. The Monetary Policy Committee (MPC) has been happy to go with one cut a quarter for the last year and we see this continuing over the rest of 2025. The big, obvious risk though, is if events in the Middle East cause a surge in energy prices that forces the MPC to skip a rate cut.

Birdwatching at the BoE: hawks and doves

To explain where we think interest rates are going, we’re going to have to get into a bit of ornithology.

The nine members of the MPC split broadly into two groups: hawks and doves.

Hawks are more worried about inflation. They generally want interest rates to be higher to try and bring inflation down quicker.

Doves, on the other hand, want to cut interest rates to support the economy. They’re more concerned that sluggish economic growth and a weakening labour market will lead to inflation dropping below the 2% target.

Both groups can point to factors in their favour.

Hawks hone in on inflation target

Hawks will highlight that at 3.4%, inflation is way above the 2% target and set to head higher over the summer.

The BoE’s own forecasts also don’t have inflation coming back down to 2% until 2027, by which point it will have been above target for most of the last five years. What’s more, regular pay growth is at 5%, which is almost double the 3% consistent with 2% inflation. That’s important because strong wage growth will encourage firms to raise prices to try to recoup their additional costs.

Inflation expectations have been rising steadily recently. That’s concerning because if households expect higher inflation, then they will bargain for bigger wage increases and firms are more likely to grant them, believing they will be able to pass on the increase in costs.

Ultimately, the hawks’ argument is that inflation looks sticky and so interest rates need to stay higher for longer to make sure inflation actually comes back to the 2% level.

Birds of a feather…are doves starting to flock together?

Meanwhile, doves will point to the sharp loosening in the labour market since the Autumn Budget in October and that wage growth has already come down from its recent peak of 6.2% and should continue to slow.

The resilience of the economy in the first quarter also looks to be fading. Growth turned negative in April and retail sales in May fell sharply. A slower growing economy will generate less inflation and need lower interest rates.

Given the MPC is generally much more concerned with where inflation will be in two years’ time, as that’s how long it takes changes in interest rates to fully flow through to the economy, the committee has to take a view on where things will be then rather than right now – hence the focus on forecasts and (usually sensible) judgement.

UK inflation still a danger

The MPC as a whole has to balance these two competing narratives by taking a “cautious and gradual” approach. Translating from BoE speak, that means the base case is one 25bp cut a quarter and would take interest rates to 3.75% by the end of the year. We have pencilled in one more rate cut in 2026 on this basis.

However, a couple of risk factors could force the MPC off that path. The most obvious and urgent are events in the Middle East causing energy prices to rise again. We don’t think the recent increase in oil prices will change the MPC’s thinking. However, a shift towards $85 per barrel or higher would probably push inflation over 4%. That’s important for the MPC because the academic literature suggests that’s when households start bargaining for bigger pay rises to protect their real incomes.

Normally, we’d expect the MPC to look through energy-driven inflation movements. This is because prices can be volatile and monetary policy can’t feed through into the economy quick enough to have a material effect. However, inflation expectations are currently far too high. A big rise in prices at the pump would push them higher and could prompt the MPC to slow the pace of easing.

On the other side of the ledger, the MPC has become much more worried about the labour market after the recent run of poor data. We expect employment to stabilise from here, but if it doesn’t, then we could see additional rate cuts to support the economy.

If we’re wrong about two more rate cuts this year, then we feel it’s more likely there will be fewer, rather than more, cuts. But much depends on how events in the Middle East unfold.

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