The week ahead: Interest rate cut inbound

03 February 2025

With a stagnant economy and all the employment indicators flashing bright red since the Autumn Budget, a 25 basis point (bps) rate cut from 4.75% to 4.5% is a sure bet on Thursday. The outlook after that is murkier though. Rising inflationary pressures, especially strong wage growth, will keep the Monetary Policy Committee (MPC) cautious. Much will depend on how firms respond to the massive increase in employment costs imposed on them by the Budget. Aggressive price hikes would lead to fewer rate cuts while cutting employment and wages could lead to more. For now, we still expect one cut a quarter this year to leave rates at 3.75%. 

Once again, the MPC’s dreaded trade-off between low growth and rising inflation rears its head. The economy has clearly underperformed since the last set of forecasts by the Bank back in November. Instead of growing by 0.3% quarter-on-quarter (q/q) at the end of last year, it looks like the economy probably flatlined. The unemployment rate is trending up and all the alternative labour market data is also pointing to a weakening labour market. 

All that suggests that not only should the Bank cut interest rates on Thursday, but it should be cutting them quite aggressively. The problem is that inflationary pressures are building again. Inflation has already risen to 2.5% and will probably tip over 3% in the spring. What’s more, wage growth is far too high for the committee to relax. In the absence of productivity gains, higher wages end up being passed through into higher prices. So, the committee is worried that it will cut interest rates just as inflation starts rising again. 

In theory, the committee shouldn’t be worrying too much about rising inflation. This is because it’s down to rising energy prices, which the MPC can’t do anything about, and the measures in the Budget, which reflect a one-off increase in the price level, rather than a sustained increase in inflationary pressures. Traditionally, it would ‘look through’ (economist language for ignore) these temporary effects as they will drop out of the statistics in a years’ time. 

However, given the recent inflationary surge, consumers are now hyper focused on inflation and inflation expectations (which are measures of where consumers expect inflation to be in a year or two’s time) are drifting up. If consumers expect inflation to be higher in the future, they’re more likely to try and demand higher wage growth and accept higher prices, which can further drive inflation in a price-wage spiral. 

As a result, the committee is unlikely to be as relaxed about temporary increases in inflation as it was previously, pointing to a more cautious stance. 

The biggest ‘known unknown’ is how firms are responding to the increase in employment and other costs imposed on them by the Budget. The Office for Budget Responsibility, which is the body that analyses government policy, assumed that 80% of the long-run cost was offset by firms paying lower wages in the future. However, survey data from the Bank of England suggests 55% of firms are planning on raising prices versus just 41% who were planning to pare back wage growth. If firms are willing and able to more aggressively pass costs on than previously assumed, it would raise inflationary pressures and mean fewer rate cuts later this year. The Bank will have to take a view on how it thinks the ‘stagflationary’ impact of the Budget will play out.

Ultimately, the recent weakness in the data will probably be enough to convince most of the committee to stick with expectations and cut interest rates by 25 bps. It may even be enough to cause one or two of them to vote for a 50 bps cut. But rising inflation and the uncertainty around the outlook mean the MPC will probably continue their cautious approach. 

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