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The Bank of England announced that the UK interest rates would remain at 5.25%, their highest in nearly 16 years.
Yet the anticipation of inflation returning to the Bank’s 2% goal soon has investors eyeing potential rate reductions.
Significant declines in energy costs since the Bank’s previous projections on November 2 have led many analysts to predict inflation, which stood at 4% in December, might reach the target by April, much sooner than the Bank’s late 2025 expectation.
Governor Andrew Bailey said, “We’ve had some good news over the past few months. Inflation has fallen a long way from 10% a year ago to 4% now. Things are moving in the right direction.”
“We have to be more confident that inflation will fall all the way back to the 2% target and stay there, and we’re not yet at a point where we can lower interest rates.”
The Bank of England cautioned last year that due to the risk of a protracted reduction in inflation, which hit a 41-year peak of 11.1% in October 2022, interest rates would need to remain elevated for a “lengthy period” and might even need to increase.
In December, three out of nine Bank policymakers advocated for a rate hike to 5.5% from 5.25%, citing that the stagnant economy had not moderated swift wage increases, a central factor influencing medium-term inflation.
However, this month, a Reuters poll suggests only one policymaker is likely to support a rate increase, with a few believing there might be a vote to lower rates for the first time since March 2020.
Mohit Kumar, the chief European economist at Jefferies, a U.S. investment bank, remarked, “The tone on inflation is likely to indicate a mini victory lap with the Bank of England satisfied with the path to lower inflation. However, it may be too soon to declare victory,” expecting one official to favour a rate reduction.
Economists surveyed by Reuters last month anticipate the Bank will start reducing rates in this year’s second quarter. Financial markets have factored in an initial rate cut by the Bank in May, with rates dropping to 4.25% by year’s end.
Unlike the Bank of England, European Central Bank officials have openly considered rate reductions last month.
Federal Reserve Chair Jerome Powell indicated on Wednesday that the U.S. central bank might lower rates this year, contingent on greater confidence in inflation consistently nearing the 2% target.
With Britain’s growth lagging in recent times and the risk of a mild, technical recession looming, the backdrop remains challenging. The International Monetary Fund predicted a mere 0.6% growth for the UK economy this year, placing it second lowest in the G7, just above Germany, which has also been severely affected by the energy price surge post-Russia’s Ukraine invasion in February 2022.
This situation poses difficulties for Prime Minister Rishi Sunak, who faces a national election within the next year. The potential for further tax reductions in Finance Minister Jeremy Hunt’s March 6 budget could lead the Bank to be wary of indicating a future policy easing.
However, a greater concern for some policymakers is the apprehension that wage inflation might not revert to the approximate 3% rate, deemed necessary to sustain inflation around 2% over the medium term.
Excluding bonuses, annual wage growth was 6.6% for the three months ending November, with many prominent employers planning around 5% for this year’s pay settlements.
Rising freight costs due to assaults on shipping in the Red Sea might also complicate rate reductions, particularly if conflicts in the Middle East continue.
Karen Ward, J.P. Morgan Asset Management’s chief market strategist for Europe, the Middle East, and Africa, suggested the Bank might consider any dip in inflation below 2% as temporary and insufficient for a rate cut. “It might be helpful for the Bank to … state at an early stage that – just as it erred away from placing too much weight on transitory high inflation – it will also place less weight on transitory low inflation,” she noted.
