Interest rate outlook – are we nearly there yet?

Like an annoying child during a long journey, markets have been asking the MPC ‘are we nearly there yet?’ with regard to rate cuts for months. So far, the answer has always been ‘nearly – just a little further to go’.

However, we think that in June, this answer will finally become a yes. We also believe two further rate cuts will follow, meaning the Bank of England’s rate is likely to finish the year at 4.5%.

Come 2025, there is a bigger chance of more aggressive cuts, if a new government instigates tighter fiscal policy than currently pencilled in.

Why the wait?

With inflation almost back at the BoE’s 2% target and the economy barely growing, the question really should be, why hasn’t the Bank already cut interest rates?

There are several reasons for the MPC to be cautious. Geopolitical events in the Middle East and Russia have caused rises in energy prices which, while not big enough yet to really change the narrative on inflation, have added to uncertainty. Expectations for a late start to rate cuts by the Fed have also raised concerns about the impact of lower UK interest rates on the pound. The main impediment to rate cuts, though, is the tightness of the UK labour market. Admittedly, at face value at least these concerns are legitimate. The official unemployment rate of just 4.2% is well below the bank’s estimate of the equilibrium rate of 4.5% and private sector pay growth of 6% is almost double the 3% - 3.5% that the bank thinks is consistent with 2% inflation.

The risk is that with inactivity levels surging and the economy starting to rebound, the labour market will remain tight and pay growth will stay above the rates consistent with 2% inflation. Given the UK’s lacklustre productivity, strong wage growth could result in a wage-price spiral where employers try to recoup higher wage costs through price rises. That would keep inflation elevated for longer and interest rates would remain high too, to dampen demand for staff and slow pay growth.

Financial markets have started to pare back bets on how many times the Bank of England will cut interest rates this year – having previously priced in a full three interest rate cuts, probably starting in June, to a bit over two, likely starting in August.

But risks run both ways

While inflation is sticky in the US – this is not directly comparable to the narrative in the UK.

Inflation is sticky in the US because demand is exceptionally strong there and, with a booming economy, the Fed feels under no pressure to cut rates. Neither is the case in the UK. Demand is still weak and although the economy has picked up recently it’s a long way off booming. That means inflation should be less sticky here and there is a much greater need to cut interest rates to support growth. By keeping interest rates well above the neutral rate of around 2.5% for longer than necessary, the Bank of England risks dampening the economic recovery or even prolonging the recession.

With the economy just emerging from a short recession at the end of last year, growth is still anaemic and likely to be just 0.3% in 2024. The risk to economic prosperity must be properly weighed against those of above target inflation.

The MPC must be proactive to kick start economic recovery

The MPC would be fully justified in cutting in June, and more aggressively so than is currently priced into the market. With inflation likely to be below the 2% target for most of the next two years, rates are clearly well into restrictive territory and are holding back the economic recovery sorely needed by the UK.

Indeed, after being late to increase interest rates during the first part of the cycle by relying on backward looking labour market data, the MPC risks being late to the party again.

While it’s true that annual headline pay growth in the private sector is 5.8%, this is primarily due to large increases in pay this time last year. Annualised pay growth over the last six months, which is a better measure of current pay pressure, is below 3%, consistent with the MPC’s 2% inflation target. What’s more, there is now clear evidence that unemployment is rising. A looser labour market combined with lower inflation means that pay growth will slow sharply in the second half of this year, removing the risk of a wage-price spiral.

By moving proactively to cut interest rates, the MPC could help to kick start the economic recovery without any real risk of higher inflation becoming entrenched.

What will the MPC do?

That said, the MPC is clearly still nervous about the outlook for inflation. As a result, we expect it to use the May meeting to lay the ground for future rate cuts by significantly reducing its inflation forecast and changing its forward guidance. The first interest rate cut will probably follow in June, although this is still a close call. By then the MPC will have hard data confirming that inflation has fallen back to its 2% target and will have measured the impact of the near 10% increase in the national minimum wage in April. The risk is that the MPC delays and the first rate cut doesn’t come until August.

We then expect the MPC to cut at every other meeting, meaning interest rates should finish the year at 4.5%. There is more scope for bigger cuts in 2025 for three key reasons:

• the labour market will probably have eased further, and wage growth will have returned to more normal levels, reducing the risks around a wage price-spiral;
• inflation will likely have spent a considerable period of time at or below the 2% target, reducing the need to keep rate in restrictive territory; and
• whichever government wins the next general election, expected to happen in the autumn, will face a difficult fiscal outlook likely to require either tax increases or lower spending. Tighter fiscal policy will give more space for looser monetary policy. We currently expect interest rates to end 2025 between 3% and 3.5%.

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