BoE delivers a hawkish rate cut, while concerns about second-round effects persist

A split committee 

In a narrow vote, five MPC members voted in favour of cutting Bank Rate by 25bps from 5.25% to 5.00%. The remaining four members, including Chief Economist Huw Pill, preferred to leave rates on hold. Bank Rate had remained at a 16-year high since August 2023, when the BoE ended a series of fourteen rate hikes since 2021 in response to rising inflation.

Chart 1. Drivers of UK Consumer Price Index (CPI) inflation and BoE projections (%)

Source: Bank of England and EFGAM. Data as of 1 August 2024.

Inflationary pressures ease

The decision was supported by a softening of economic data since the last MPC meeting in June. In particular, lower services inflation and a loosening labour market gave BoE officials sufficient evidence that inflationary pressures have abated, warranting an easing of monetary policy. Nonetheless, MPC officials highlighted continued concerns about the persistence of second-round effects that might require monetary policy to remain restrictive for longer.¹

The month-on-month decline of services prices and wages have not been as pronounced as some members expected. However, the consensus in the MPC is that the impact from past external shocks is fading and the normalisation of inflation expectations will feed through to a moderation in wage growth and price setting behaviour by firms. All this would, in turn, reduce services inflation going forward.

According to a survey conducted by the Office for National Statistics (ONS), non-wage costs have become a less important determinant of services firms’ price setting decisions, while wage pressures continue to play a key role.² The BoE noted that headline inflation was at the 2% target in both May and June, primarily reflecting favourable base effects for energy prices. MPC members expect inflation to rise again, to 2.75% year-on-year (YoY) in H2 2024, as these base effects drop out of the inflation calculation, revealing the persistence of domestic inflationary pressures and warranting caution on the path for further rate cuts (see Chart 1).

Chart 2. Summary of economic projections

Source: Bank of England Monetary Policy Report, August 2024.

The restrictive stance of monetary policy will continue to affect economic activity in the coming months. MPC estimates suggest that most of the impact of higher interest rates has already fed through to GDP growth. Therefore, the MPC’s base-case is that, going forward, second-round effects in inflation from previous shocks fade without much impact on activity.

As such, GDP growth forecasts for this year rose, with growth now expected to reach 1.25% YoY in 2024 but decelerate to 1% YoY in 2025 (see Chart 2). This, in part, reflects the continued restrictive stance of monetary policy, with unemployment projected to increase to 4.8% before receding again.

The MPC’s concern over persistent second-round effects can be interpreted as a signal that they will follow a cautious approach in the coming months, with a slow pace of monetary policy easing.

Monetary policy outlook

Further policy decisions will remain dependent on upcoming economic data. However, rather than having a specific target for the change they expect to see on key variables such as services inflation and wage growth, officials will look at the medium-term outlook, assessing how restrictive monetary policy is and how much slack it has created in the economy. Although this means little forward guidance is provided, it gives the MPC a level of flexibility to operate based on the transmission mechanisms of monetary policy to the economy.

For the time being, the MPC reiterated that rates will need to remain restrictive for long enough to ensure the risks to inflation returning sustainably to the 2% target have dissipated further. Markets are currently pricing in a further one to two rate cuts before the end of the year.

¹ Second round effects occur when inflation has an indirect impact on wages and prices, potentially leading to a wage-price spiral.
² ONS Business Insights and Conditions Survey (BICS)