22 January 2025
In an interview in the Financial Times in December, Bank of England (BoE) Governor Andrew Bailey offered a less guarded outlook on the trajectory of interest rates for the coming year. He acknowledged the uncertainty surrounding inflation but indicated that the central bank's primary projection suggests a gradual path of interest rate cuts. When pressed on "gradual," Governor Bailey clarified that this translates to approximately 0.25% per quarter. This trajectory would result in UK interest rates reaching 3.75% by the end of 2025. Interestingly, market expectations for the UK Official Bank Rate (OBR) are higher, at 4.07% (as of 20 January).
So where do we stand now, after the Bank’s final Monetary Policy Committee (MPC) meeting of 2024. And what could result in the Bank having to change its gradualist approach?
Why does the BoE’s preferred path involve limited and gradual rate cuts?
The global monetary policy landscape is undergoing significant shifts, with a discernible trend to more accommodative stances. Central banks across Europe, including the European Central Bank, Sweden’s Riksbank and the Swiss National Bank, are increasingly signalling a dovish bias, i.e., a preference to lower interest rates acknowledging the intensifying economic headwinds.
In contrast, the BoE maintains a more cautious approach. After its cut to 4.75% in November, the MPC held its OBR steady in December, despite a surprising three votes in favour of an immediate reduction by 0.25%. The MPC’s minutes repeated key policy guidance, most notably a nod to further gradual, and probably limited, rate cuts. Five MPC members who voted to leave rates unchanged said that they wanted to gain greater confidence about the performance of the UK economy before easing again.
So why is the MPC cautious, compared to their European counterparts? Essentially, the bank is trying to navigate stagflationary pressures – persistent inflation alongside a slowing economy. Most indicators of UK near-term activity have weakened, but some components of consumer price inflation (CPI) are still running well above their long-term averages, at a level inconsistent with the BoE’s 2% inflation target. That is, most notably, the case for hard to control, domestically generated services inflation. The key cause of services inflation is the persistence of above-expectation wage growth in the private sector. The BoE will no doubt be concerned that almost half of CPI items have their prices growing at above 3%. This number would need to fall back to closer to 30%, by historical standards, for stable 2% price increases.
These pressures are being offset against real and growing concern at the Bank surrounding the strength of the UK economy. A key point from December’s MPC is that a larger-than-expected minority of MPC members are becoming more concerned about the slowing economy. BoE staff now expect gross domestic product (GDP) in the fourth quarter of 2024 to stagnate – a downward revision from the +0.3%, quarter on quarter, forecast at the previous MPC meeting.
These conflicting pressures are why the BoE is in an increasingly difficult position. They are why the Bank prefers to make cautious interest rate cuts, while keeping its guard up against any resurgence in inflation. But what could change this approach?
Why might the BoE accelerate its easing plans?
The bigger picture is that the UK economy experienced a sharp loss of momentum in the second half of 2024. The measures announced in the Autumn Budget are likely to see the UK economy return to growth as we move into 2025. However, most economists expect that growth to be tepid at best, and to fall short of the 2% rebound that the Office for Budget Responsibility anticipates for 2025.
Further headwinds include a deteriorating EU economy, which is likely to reduce demand in the UK’s largest trading partner; a position which may get even worse should the incoming US administration impose trading tariffs. There is also uncertainty surrounding how the increase in employers’ National Insurance Contributions (NICs) in the Autumn Budget will feed into companies’ appetite for hiring. Those higher NICs represent an increase in business costs of just under £20 billion from April 2025. It is likely that some employers may choose to cut back on staffing, which would impact economic growth.
Should a combination of these risks materialise, we may see the bank stepping up the pace of rate cuts. Only two MPC members would be needed to join the three who voted to cut rates last month. Any such change, however, looks likely to occur in the second half of the year, once the BoE has reviewed data that incorporates the jump in NICs. The geopolitical landscape that emerges from the Trump presidency will also be better known by then.
Are interest rate increases completely out of scope?
Not completely. In fact, one of the MPC members who voted for a hold at the December meeting appeared to hint that she considered a rate hike. The meeting minutes said that one member saw a case for ’an activist strategy’. That is central bank speak for potentially acting more aggressively with regards to interest rates.
The BoE’s most recent CPI forecasts included the expected inflationary impact of the government spending commitments announced in the Budget which could create inflation in some sectors where there is limited spare capacity. Should this combine with businesses passing on the NIC increase to their customers, and planned increases in the national living wage, we may once again be in a position where inflation moves higher and the Bank may need to react. In a survey of 5,000 businesses by the British Chambers of Commerce published this month, about 55% of companies said they were planning to increase prices in the coming three months.1
Other, more extreme, scenarios may also result in interest rates moving higher. The incoming Trump administration could implement policies that may be inflationary globally. A growing lack of confidence in the UK’s public finances and the Chancellor’s ability to borrow in the gilt market may result in higher interest rates becoming the new normal.
How are we managing the Public Sector Deposit Fund in light of this uncertainty?
We anticipate that concerns about the economy will eventually outweigh other factors. This would lead the BoE to marginally increase its pace of rate cuts as it seeks to support the economy and labour market. However, this stance will not necessarily become clear early in the year, when inflation and wage growth will remain too high for comfort.
Given our view, the current money market presents us with opportunities. Although the MPC continues to hint that rates will slowly move lower, yields, particularly for longer-dated investments, experienced a slight increase. This has presented an opportune moment for us to extend the fund’s duration and secure more favourable yields. We executed this re-positioning predominantly during the last six weeks. Despite our view, we remain alert to the prospect of rate volatility that we saw throughout 2024 continuing into the new year.
Important information
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