Hold for now. Next move depends on energy prices
The Bank of England is all but certain to leave interest rates unchanged at 3.75% next week.
With the decision itself largely a done deal the focus will be on the vote split and the guidance. We expect two members to vote for a rate hike again next week, given that the Strait of Hormuz is closed again, and surveys suggest underlying price pressures are rising. There will also be an element of “talking the talk”, with the guidance not pushing back against market pricing of two to three rate rises in the next year and emphasising that the committee remains “ready to act”.
Further ahead, the path of interest rates over the next year will largely depend on oil prices. If they remain close to $100pb over the summer, a September rate hike would move firmly onto the table with another in the winter likely. However, if there is another peace deal and prices drop back a little, then we think a weakening labour market and deteriorating economic outlook will keep the Bank on hold this year before cutting three times in 2027.
Resilience is the word of the month
The theme of the data flow since the last Monetary Policy Committee (MPC) meeting has been resilience. The 0.1% gain in May means that Q2 GDP growth will come in at 0.3% q/q, or even 0.4%. That’s despite the triple whammy of war in the Middle East, higher energy prices and another bout of political uncertainty. The MPC had pencilled in growth of just 0.2% q/q for Q2, so growth now looks almost certain to beat that. Indeed, the economy has performed remarkably well over the last couple of years given the geopolitical and political headwinds, with growth averaging 1.0% y/y since the start of 2024.
At the same time, the labour market appears to have stabilised, albeit at a relatively soft level. The unemployment rate stayed at 4.9% in May, the vacancies-to-unemployment ratio is little changed this year, and payroll numbers have been fairly flat since April. Private sector pay growth has slowed significantly, but forward-looking surveys suggest wage pressures may soon stabilise. All that suggests the labour market has come through the worst of the policy-induced weakening and has weathered the Iran storm reasonably well.
Even inflation has been well behaved, with the headline measure of 2.6% in June coming in well below the MPC forecast of 3.1%. However, services inflation, which is more important for the MPC because it is a better measure of domestically generated inflation, was in line with the forecast. Importantly, there has been little convincing evidence of second-round effects coming through in the inflation data so far.
Taken together, the latest data leave both sides of the committee with little reason to change course. The doves can point to softer headline inflation and cooling wage growth, while the hawks can take comfort from an economy that continues to outperform expectations.
Risks heavily weighted towards rate hikes
Beyond next week’s meeting, the outlook for interest rates is heavily dependent on how energy prices move over the summer. The risks are weighted towards rate rises for three reasons.
First, the most obvious risk is that energy prices continue to rise. Oil prices are almost back at $100pb, with no signs of an imminent peace deal between the US and Iran. What’s more, European natural gas storage levels are below their seasonal 10-year minimum, raising the prospect that gas prices could rise sharply if flows continue to be restricted and there is a cold winter.
Second, inflation is likely to accelerate in the second half of the year, despite the cut to VAT on electricity bills. PMI surveys suggest firms are preparing to raise prices to protect margins. Tomorrow's Decision Maker Panel survey is unlikely to materially alter that picture.
Third, even though the MPC can only take announced government policy into account, the direction of travel under the new administration is clear. The broad direction of fiscal policy points towards stronger demand over the medium term, increasing the risk that inflation proves more persistent than the MPC currently expects.
Ultimately, the recent data suggest that the economy has weathered the latest war in Iran well, and there has been little sign of second-round effects emerging. That will give the MPC room to keep rates on hold next week. That said, the MPC won’t want to push back too hard against market pricing, which is tightening financial conditions in the economy and doing some of its work for it. That means the guidance will probably keep an emphasis on being “ready to act” and highlight the risk of the latest energy spike and of second-round effects emerging.
Our central forecast remains that rates stay on hold through the rest of the year. The labour market is still soft enough, and growth weak enough, to prevent a sustained pickup in domestically generated inflation. But that forecast depends heavily on energy prices easing. If oil and gas remain close to current levels through August, we would probably shift to expecting two further rate increases over the coming year, particularly if the Autumn Budget delivers another dose of fiscal stimulus.