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Bank of England: laying the groundwork for a rate cut

On Thursday at Midday the Bank of England will deliver their second Monetary Policy Report of the year so far. The bank will announce their decision on interest rates as well as their latest economic analysis and projections for inflation. The Monetary Policy Report is important since it is seen as a road map for future policy decisions, and it can have a big impact on UK asset prices.

The BOE is not expected to change interest rates at this meeting, instead the focus will be on economic and inflation projections for the short and long term. The market will want to know how the inflation forecast has shifted since the last Report in February. Back then the BOE had revised down their median CPI inflation forecasts to 3.7% for 2024, down from 4.4% in November, and inflation was expected to fall back to 3%in 2025. The BOE did not expect inflation to reach its target 2% annual rate until 2027. The BOE said in February that it expects inflation to be bumpy in 2024. Inflation may have already fallen to 2% in April, we won’t find out until May 22^nd when April CPI is released, however, the BOE sees inflation picking back up again later this year. The BOE also cautioned that another shock could trigger another steep rise in inflation.

The Goldilocks effect

The market will be looking to see if the BOE is a little more confident about the outlook for inflation at this meeting now that 1, the oil price has moderated back to the low $80s. Brent crude is currently trading at $82 per barrel and is lower by 8% in the past month. 2, there has, so far, been no external inflation shock that is putting upward pressure on energy prices. The fly in the ointment is still wage growth, which at 6% remains high, but it has still fallen sharply. Wages are a key contributor to inflation, so the BOE will likely remain wary about sounding too confident on the inflation outlook, even though progress has been made on inflation in recent months. For example, in March annual UK inflation fell to 3.2%, which is well below 3.7%, the current BOE median target for inflation for the whole of this year. Thus, the BOE could be justified in revising down its inflation forecast for this year in this report.

The BOE sets policy based on inflation returning to 2% in the medium term. Thus, the longer-term inflation forecasts are also worth watching. If the BOE brings forward its expectations of when the 2% inflation target will be reached to 2026, currently it is 2027, that could be seen as a dovish sign that may open the door to a summer rate cut. The BOE will also report their GDP forecasts. The economy is expected to return to growth in Q1, after a shallow recession at the end of 2023. Currently, economists are more bullish about the UK economy than the BOE. The BOE’s February GDP forecasts were revised lower to 0% for Q1, however, growth is expected to be 0.4% when it is released later this week. Thus, there is a strong chance that the BOE will also revise their GDP forecasts.

An upgrade to GDP and a downgrade to CPI would be a Goldilocks scenario for the UK economy and would suggest that the UK economy will get its soft economic landing after all.

The rhetorical shift at the BOE

Recent speeches from MPC members suggest that there remains a range of views at the Bank, but that there could be the start of a tilt towards a loosening bias. For example, Jonathan Haskel, who voted for a rate hike earlier this year, said that the timing of a rate cut will depend on the vacancies to unemployment rate, which is 30% down from its peak. He also said that inflation expectations remain well anchored, which suggests that he has shifted his hawkish stance. Andrew Bailey, the Governor of the Bank of England, has said that the UK is going through a dis-flating process at full employment, and that this will continue. New member Megan Greene and Huw Pill who have said that the bigger risk could be cutting rates too early only to hike them again down the line. Interestingly, no recent speech from a BOE member has spoken about high levels of inflation, or the prospect of more immediate rate hikes. We will also be looking at the vote split on Thursday. There could be a 7-2 split in favour of remaining on hold, with two members voting for a cut, which would suggest that the BOE is moving towards a rate cut later this year.

When will the BOE cut rates?

The BOE dropped its tightening bias in March and said that it could still cut rates at the same time as having a restrictive monetary policy. The chart below shows real interest rates (adjusted for inflation) for the UK and the US. The real UK interest rate is 1.77% and is 2% for the US. The question is, are real rates restrictive in the UK? The real rate is currently higher than the average UK base rate (not adjusted for inflation) of the last 5 years and is well above the average unadjusted UK base rate of the last 10 years, which is 1.02%. Thus, UK real interest rates could be considered restrictive based on recent historical norms, which gives the BOE scope to cut rates.

Chart 1: UK and US

Source: XTB and Bloomberg

The market impact

The market is expecting the first rate cut from the BOE between June and August. If the BOE does intend to cut rates next month, then we would expect to get a clear indication from the Bank on Thursday that this could happen. We would also add that the BOE tends to make big changes to monetary policy at the same time that it releases Monetary Policy Reports, thus the BOE may choose to wait until August before cutting rates. If a June rate cut is ruled out on Thursday, then the market could be disappointed, sterling may rally, and UK Gilt yields could rise.

The market appears to be positioning for a dovish tilt from the BOE ahead of Thursday. GBP/USD is below the $1.25 handle, 10-year UK Gilt yields have fallen by 15 basis points in the past week, and 2-year yields are lower by 20 basis points in the past week. The FTSE 100, which tends to move inversely to the pound, reached another record high on Tuesday, and has outperformed European and US indices in the past month. The FTSE 250, which is a more domestically focused index, has tracked the FTSE 100, as it benefits from the prospect of lower borrowing costs in the UK.

Chart 2: FTSE 100 and FTSE 250, normalized

Source: XTB and Bloomberg

Will the BOE change its methodology?

Another factor to look out for is whether the BOE will shift its forecasting models or update the Monetary Policy Report after a review by former Fed chair Ben Bernanke raised concerns about the quality of the BOE’s forecasting. While change is coming, we think it is unlikely that any changes will be announced on Thursday, but if they are then the media is likely to focus on this.