(Bloomberg) -- The Bank of England opened the door to interest-rate cuts for the first time since the pandemic struck — affirming predictions that inflation will fall to target this spring — while warning that price pressures could reemerge.
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The UK central bank removed key guidance that borrowing costs may have to rise again, with Governor Andrew Bailey acknowledging that keeping rates unchanged would push inflation “significantly” below the target of 2%. The nine-member Monetary Policy Committee split three ways on how to act, with a majority of six opting to leave the key rate unchanged at 5.25%.
Still, MPC member Swati Dhingra pushed to cut rates, the first vote for a reduction in almost four years. Catherine Mann and Jonathan Haskel stuck with their previous position to raise rates to 5.5%.
Traders held bets that the BOE will deliver at least four quarter-point interest-rate cuts this year, with the first coming in June. The chance of an earlier move in May remains at around 50%.
“Cuts could happen from the summer onwards, by around 100 basis points in total this year, with interest rates potentially settling at around 3% by the second half of 2025,” said Yael Selfin, chief UK economist at KPMG.
The pound traded slightly weaker against the dollar and the euro, but above the levels reached earlier on the day as strategists took the BOE’s message as more hawkish than expected. Gilts rose, with the 10-year yield dropping two basis points to 3.78%.
The MPC decision marked the widest division on the direction of policy since 2008, a potential turning point in the BOE’s fight against inflation. The bank had come under pressure in recent weeks to adjust its relatively hawkish stance compared with the Federal Reserve and the European Central Bank and, on Thursday, Baily stepped back from recent remarks when he said there was a way to go before price pressures were contained.
“We’ve come a long way,” Bailey told reporters in London after the decision. “But we’re not there yet.”
For Bailey, one of the big unknowns that could shift the outlook is a potential stimulus coming from Prime Minister Rishi Suank’s government in the next budget. Chancellor of the Exchequer Jeremy Hunt is preparing a statement in early March and wants to find room for tax cuts that could help the ruling Conservative Party’s standing in polls against the Labour opposition.
“While the UK Chancellor has looked to play down speculation around pre-election fiscal giveaways we still expect the government will implement some personal income tax cuts at the upcoming Budget,” said Henry Cook, senior economist at MUFG EMEA. The BOE’s restrictive monetary policy setting could be pitted against more accommodative fiscal policy in the months ahead.”
The BOE dropped its guidance that “further tightening would be required,” if inflation proved persistent. Instead, it reiterated that rates would need “to remain restrictive for sufficiently long to return inflation to the 2% target.”
Forecasts in its February Monetary Policy Report also pointed to looser policy. On the constant rate path, which assumes the benchmark lending rate sticks at 5.25%, inflation falls well below the 2% target to 1.4% at the two-year horizon and 0.9% in three years. That suggests policy is much too tight.
Using the market path for rates to be cut to 4% this year and 3.5% in 2025, inflation is above target after two years, at 2.3%, but dips to 1.9% at the three-year horizon. That appears to imply rates should fall, but not as quite as steeply as the market thinks.
“Despite a vote for an immediate rate cut, it still looks hawkish compared to what was priced in,” said Kamal Sharma, a strategist at Bank of America. “Looking at the inflation forecast — 2.3% by 2026, they want to signal that we are not there yet on inflation and rate pricing excessive.”
The UK has been lagging behind the US Federal Reserve and the European Central Bank, both of which have signaled that rate cuts are probable in the months ahead. Until now, the BOE has stuck to its warning that rates are more likely to rise than fall.
What Bloomberg Economics Says ...
“The Bank of England is warming to the idea that it will likely be able to cut interest rates this year. A vote for a cut, softer guidance and a forecast that endorses the idea of multiple rate reductions this year, all support the view that the next move is likely to be down, it’s just a question of when. Our base case remains for a first cut in May.
— Dan Hanson and Ana Andrade, Bloomberg Economics. Click for the REACT.
The UK economic backdrop has transformed since the BOE last met in December, with inflation dropping more sharply than anticipated. Officials now believe consumer-price inflation will be at the 2% target in the second quarter, thanks to tumbling energy prices. That’s more than a year earlier than the BOE projected at its last forecasting round in November.
However, inflation then is likely to bounce up to almost 3% as the impact of cheaper energy fades and underlying prices pressures in services and wages persist. The BOE cautioned that inflation risks remained “skewed to the upside,” and disruption in the Red Sea posed a potential price threat.
“If we were to keep bank rate at 5.25% for the next three years, we think it is likely that inflation would eventually fall significantly below target,” Bailey said. “But if we were to follow the market rate conditioning path, we think inflation would be above target for much of the next three years. We need to get the balance right.”
Lower inflation and rates buoy the economy. The BOE expects an expansion of 0.25% this year, up from near zero in November. For 2025, the economy could show 0.75% growth, also stronger than before — reflecting an easing of the cost-of-living crisis. About two thirds of the impact of higher rates since the tightening cycle began in December 2021 has now come through, the BOE said.
The MPC was deeply divided over how to act. Dhingra voted to cut rates to 5%, arguing that there’s now a risk of overtightening. Megan Greene, who had voted for a hike in December, rejoined Bailey with the majority opting for no change.
Not since summer 2008 have the MPC members voted for a rate rise, a rate cut and a hold at the same meeting. In August, a month before the MPC ended its quickest round of rate hikes in decades, the committee split three ways but the division was over the pace of rate rises.
In its annual supply-side stocktake, the BOE raised its estimate of the economy’s speed limit. It now puts potential supply growth at around 1.25% on average over three years, up from less than 1% when the assessment was made a year ago.
--With assistance from Greg Ritchie, Anchalee Worrachate, Andrew Atkinson and Lucy White.
(Updates with market reaction in third paragraph.)
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