Monetary Policy Committee preview: MPC risk falling behind the curve if they don’t cut next week

At face value, the decision to cut interest rates at the next meeting on 1 August should be pretty easy now that headline inflation is back at 2%. The last time inflation was 2%, back in May 2021, interest rates were just 0.1% and the previous communications from the Monetary Policy Committee (MPC) make it clear that they are itching to cut rates. What’s more, the unemployment rate has jumped from 3.8% in December to 4.4% in May and wage growth has slowed sharply over the last two months, a sign of a weakening labour market.

However, financial markets are only pricing in a 50:50 chance of a rate cut. This is because while headline inflation is back at 2%, services inflation is stubbornly stuck at 5.7%. And with the economic recovery from last years mini-cession proving much stronger than anticipated, the need for rate cuts to support the economy seems to have diminished. 

We think the first argument should (and probably will win out) and the MPC will cut interest rates by 0.25 percentage points (ppts) to 5% at its meeting next week. The MPC has made it clear that they want to cut interest rates soon and are not too concerned by overshoots in the data. In any case, given the large amount of spare capacity in the economy, a few quarters of strong growth won’t be enough to push the economy towards overheating and the labour market is clearly loosening now. In addition, the MPC has made clear that, given how high interest rates are currently, it can cut them and they would remain in restrictive territory. 

Failure to cut interest rates next week would risk the MPC falling behind the curve now that other major central banks, such as the European Central Bank and Bank of Canada, have cut rates and the Fed is widely expected to cut rates in September. 

Even so, it will be a close call and is unlikely to be a unanimous vote. A 50:50 chance feels about right. In any case, we expect the MPC to cut rates only gradually this year, with another cut probably coming in November. 

Three reasons not to cut rates – and why they should be ignored 

The strong rebound means there’s no need for rate cuts

It is true that the recovery from the recession in the second half of last year has been much stronger than anyone expected. Growth jumped by 0.7% quarter-on-quarter in Q1 and looks like it will come in at around 0.6% in Q2 - well above the MPC’s forecast of 0.4% and 0.2% respectively. 

The key judgement the MPC needs to make at its August meeting is to what extent this recovery is primarily demand driven – which could signal the economy is overheating – or supply driven, which would not impact inflation. In our view, a rebound in supply probably accounts for most of the pick-up. The unemployment rate is above its equilibrium level and is rising, survey data suggests firms have plenty of spare capacity and pay growth continues to ease. 

In any case, the economy probably had at least 1% of spare capacity at the end of last year, so the recent surge in growth has only reduced that to about 0.5%, still a way off concerns about overheating. 

Admittedly, the MPC will be wary about the prospect of above trend growth pushing up inflation. But after such a long period of below trend growth (practically zero growth!), a bit of above trend growth should be welcomed rather than feared. 

Wage inflation is still too strong

It is true that at 5.1% wage growth is still well above the 3.0% to 3.5% rate that the MPC think is compatible with 2% inflation. However, total wage growth has slowed from 6.4% in March to 5.1% in May and even more importantly private sector wage growth has slowed even more sharply, from 6.8% to 4.7% over the same time frame. Pay growth is clearly slowing rapidly, despite the huge increase in the minimum wage in April. 

Throw in the evidence that the labour market is loosening, such as the sharp jump in the unemployment rate, and that pay growth is likely to fall further in the second half of the year now that future pay deals will be set with 2% inflation in mind, and it seems likely that pay growth will be around the crucial 3.5% mark before long. 

Sticky services inflation

In our view, this is the most likely reason for the MPC to hold off from rate cuts in August. At 5.7% in June services inflation has dropped by less than 1ppt this year and is still 60 basis points stronger than the MPC expected. 

However, rate setters will look through the upside surprise in June because it was driven by a surge in domestic hotel and live music event prices that will likely unwind (Taylor Swift’s groundbreaking Eras tour landing in the UK is probably largely to blame here!). 

Admittedly, getting inflation sustainably back to the 2% target will require services inflation to drop closer to 3.5%, and that will take time because wage growth remains strong. But, as wage growth continues to slow, it will feed into gradually slowing services inflation. If the MPC waits for services inflation to fall back to 3.5% before it starts rate cuts, not only will it have fallen well behind the curve but it will also have unnecessarily delayed the long-awaited economic recovery. 

What will the MPC do?

Weighing all these arguments up is no easy task and different members of the committee will put different weights on each one. The vote won’t be unanimous, Chief Economist, Huw Pill has as much as said he wants to keep rates where they are for example. But we think a majority of the committee will be convinced that there is enough evidence to start cutting rates. 

Indeed, the June MPC minutes reiterated the point 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'. This is more akin to the MPC slightly easing off the breaks, rather than pressing down on the accelerator. We view this guidance as a path to cuts unless there are big upside surprises.

As such, we expect a 25 basis points (bps) cut next week to be followed by at least one more 25bps cut, probably in November, meaning rates would end the year at 4.75%. 

In our view, a delay beyond August would be a mistake. Inflation is back at normal levels and services inflation will slow sharply soon, the labour market is clearly loosening and there is still substantial spare capacity in the economy. A gradual reduction in interest rates would support growth, without risk of reigniting inflation. 

Sign up to our Real Economy communications for regular commentary and analysis from Tom on the changing economic landscape.