Monetary Policy Committee preview: Markets pendulum has swung too far

08 May 2024

The Monetary Policy Committee (MPC) will almost certainly keep interest rates on hold at its next meeting on Thursday 9 May. The main focus, therefore, will be on the new forecasts, any change in the minutes and the vote split. We expect the committee to start to lay the groundwork for rate cuts to start in the summer through it’s new forecasts. Most committee members have shown little concern over the minor upside surprise to recent data releases. However, the vote will remain split, probably at 8-1, with the possibility of a 7-2. We still have a base case of the first rate cut coming in June and that being followed by two more to leave interest rates at 4.5% by the end of the year. However, the risk is that the Bank chooses to start later and cut by less. In our opinion this would be a mistake.

Financial markets have overreacted to only slightly stronger data

Financial markets have gone from pricing in over five rate cuts at the start of February, to three by the time of the next MPC meeting in mid-March and is only expecting 1.5 cuts now. There are some legitimate reasons for this pull back, but it looks like an over-reaction to us.

Admittedly, the economy has recovered more quickly than expected from last years mini-recession. Growth is now looking like it will come in at about 0.4% in Q1, well above the MPC forecast of 0.1%. But inflation has been more or less as expected – a 0.1 percentage point miss is well within the margin of error for all economic models.

Pay growth has also been slightly stronger than expected and the jump in the minimum wage in April has raised risks of a reacceleration in pay growth. However, this has been partly offset by a jump in the unemployment rate suggesting that the labour market is easing.

The other major issue that has spooked markets is sticky US inflation, but 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.

So, while five rate cuts always looked ambitious, we now think that the markets pendulum has swung too far the other way. Indeed, the Bank would be fully justified in cutting rates in June if inflation has fallen back to the 2% target, as expected in April or May.

This meeting

Some members of the MPC are clearly still nervous about the outlook for services inflation and wage growth, which makes for a tricky communications challenge so it is unlikely to send a strong signal. But the previous guidance has left the door open to rate cuts. The MPC has made the point that interest rates don’t have to remain at 5.25% in order to be restrictive. The March MPC minutes argued that “the restrictive stance of monetary policy is weighing on activity in the real economy, is leading to a looser labour market and is bearing down on inflationary pressures... monetary policy could remain restrictive even if Bank Rate were to be reduced”. We view this as a path to cuts unless there are big upside surprises.

The forecasts will also be worth watching. Back in February, the forecasts suggested that if the MPC didn’t cut rates inflation was likely to fall below the 2% target, we expect the new forecasts to reinforce that message next week. Essentially this will be a pushback against the recent swing in financial markets expectations on the back of stronger US data. The UK economy is not in the same place as the US economy and there is therefore no reason why monetary policy shuoldn’t start to diverge.

Admittedly, the vote split on the committee will probably still be 8-1 hold-cut. It will be a while before the three more hawkish members of the committee (Catherine Mann, Jonathan Haskel and Megan Greene) are ready to cut. But the rest of the committee will likely have seen enough evidence of falling inflation and a weakening labour market by the June meeting.

Further ahead

We still expect the first interest rate cut to come in June, although this is now 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 and that there are only two cuts this year.

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:

  1. 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;
  2. 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
  3. 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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