BoE keeps rates on hold and signals potential cut in the summer

As expected by markets, the BoE kept interest rates unchanged at 5.25% at its meeting on 9 May. However, two MPC members voted in favour of a rate cut. The Committee highlighted positive surprises in recent economic data but stressed the need for monetary policy to remain restrictive for the time being to ensure inflation returns to the 2% target.

Second-round effects in domestic prices and wages are expected to take longer to unwind. The Committee therefore needs more evidence that inflation pressures have abated before easing monetary policy. The May Monetary Policy Report showed the BoE expects inflation to decline to close to 2% by the end of Q2, before rising again to 2.6% in Q4 due to energy-related base effects.

Although developments in the Middle East have been largely contained and have not translated into higher oil prices, the Committee highlighted it cannot rule out additional global shocks that generate further inflationary pressures.

A more dovish tone from the MPC was followed by an improvement in macroeconomic data. Quarterly GDP was up by 0.6% in Q1, beating expectations and marking a recovery from last year’s technical recession. Growth in Q1 was boosted by services and production, which saw output growth of 0.7% and 0.8% quarter-on-quarter (QoQ) respectively, offsetting the decline in construction by 0.9% QoQ. BoE staff estimates that two-thirds of the impact of higher interest rates on the level of GDP has already come through. However, they expect growth to decelerate in Q2 to 0.2%, increasing the odds of a rate cut later in the year.

Although MPC members did not hint at when they intend to start cutting interest rates, the decision will most likely depend on three variables: the tightness of the labour market, wage growth and services inflation.
 

• The labour market has started to loosen, as shown by a continuous reduction in job vacancies. Employment growth has declined since the start of 2023, and the unemployment rate has increased to 4.2% as of the end of February (see Chart 1). Nevertheless, the Committee continues to believe that the labour market remains tight. There is a considerable degree of uncertainty around statistics derived from the Labour Force Survey given its low response rate.

Chart 1. Labour market indicators start to loosen

Source: LSEG Data & Analytics and EFGAM. Data as of 10 May 2024.

• Wage growth has declined faster than what was expected by the MPC. Growth in average weekly earnings declined to 6.0% in the three months to February 2024 (see Chart 2). A softening of the labour market explains part of the moderation in wage growth. Although progress has been slow so far, wages are expected to continue to soften in the coming two months, easing pressures on inflation.

Chart 2. Average weekly earnings slow less than expected (3m avg. % YoY)

Source: LSEG Data & Analytics and EFGAM. Data as of 10 May 2024.

• Services inflation remains elevated at 6% year-on-year, declining less than goods inflation. This has been attributed to i) the labour-intensive nature of services, and ii) the effect from rising rents. The latter reflects strong rental demand following the pandemic and reduced supply of units to rent. The MPC expects services prices to continue to decelerate in the coming months, falling below 5% by September. 

In February Catherine Mann, an External member of the MPC, described what she called the “target-consistent combination” of goods and services price inflation which would be required for inflation to return to the 2% target (see Chart 3). She highlighted that between 1997 and 2019, services inflation ran at an average of 3.5%, while core goods inflation averaged -0.6%, and CPI inflation was at target.

Chart 3. Core goods and service inflation and BoE target (% YoY)

Source: Bank of England, LSEG Data & Analytics and EFGAM. Data as of 10 May 2024.

Not all MPC members will have adopted the same thresholds as part of their decision-making framework. Additionally, voting members do not need to wait for data to reach target levels before voting for a change in policy, but they will want to ensure inflation pressures are abating. However, it is reasonable to infer that it will take further progress on services inflation to convince the Committee to vote in favour of a rate cut.

Markets currently assign a probability of 45% to a rate cut in June. We believe that this will be highly dependent on the evolution of labour market conditions, wage growth and services inflation. So far, we have maintained that the first rate cut would come in August, however a cut as early as June cannot be ruled out.