The week ahead: no rate cut this week, but more to come this year

It’s more or less a foregone conclusion that the Bank of England will keep interest rates on hold at its meeting on Thursday. Financial markets are pricing in just a 3% chance of a cut. The more interesting question is how the vote will be split. This will give us some insight into how likely a cut in May is.

It’s not difficult to see why the Monetary Policy Committee (MPC) might want to keep rates on hold this month. Inflation has risen to 3% and is likely to go to within touching distance of 4% before long.

Firms will be grappling with the surge in employment costs coming in at the start of April that they will likely try to pass on. At 6%, wage growth remains well above the 3% consistent with 2% inflation.

As if that wasn’t enough, tariff uncertainty is everywhere and now there is the possibility of a huge fiscal stimulus on defence coming over the next few years.

All this means the MPC will most likely stick with its guidance that “a gradual and careful approach to the further withdrawal of monetary policy restraint is appropriate”. In other words, don’t expect any big moves in rates or for them to go anywhere quickly.

The vote split on the MPC is normally pretty predictable, but this time its trickier. Two members voted for a 50bps cut last month. At least one of them will again. If there are more votes for a 25bps cut – or even for 50bps – then it would make it even more likely that rates come down again in May.

There are three big uncertainties that will influence where interest rates go this year.

First, what on earth is going on with the labour market? Surveys of employment have fallen off a cliff since the budget, but the official data has held up better. In our view, the labour market is weakening, but not collapsing, as firms press pause on hiring rather than resorting to layoffs. With that in mind it’s a little puzzling why wage growth is so strong. One possibility is that consumers and businesses are expecting inflation to be higher over the next year and are therefore factoring that into their wage negotiations. If that is true, then the MPC will be even more reluctant to cut rates quickly because it risks these higher inflation expectations becoming entrenched – that’s a red line for the MPC.

Second, tariffs. The tariff situation is fluid to say the least. Inflation in the UK doesn’t seem to have been materially impacted by tariffs yet, but tit-for-tat tariffs and disruption to supply chains in North America and Europe will push up prices for everyone, including the UK. The MPC will, however, have to take a view on to what extent tariffs’ knock to growth will offset the impact on inflation (lower growth means lower inflation in the medium term). That’s a trickier call.

Third, how will firms respond to the surge in employment costs in April? Surveys suggest the hit will partially be absorbed through lower profits. Some of the cost will be passed on and some will be absorbed through employing fewer people. The risk is that firms are much more aggressive in passing on price increases than expected. This would lead to higher inflation and fewer rate cuts. Or, there is a much bigger impact on employment and wages than expected, which would allow the MPC to cut rates by more.

For now, we expect the MPC to cut interest rates at every other meeting this year, which would mean the next rate cut comes in May and rates finish the year at 3.75%. But there are plenty of risks around. The biggest is that the combination of price rises, tariffs and worries about a coming big rise in defence spending causes the MPC to go from cautious rate cuts to careful rate holds.

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