BOE preview: Inflation stands in the way of more rate cuts

Two days, two key central bank meetings, a state visit and £150bn in investment from US tech giants into the UK, it’s been a busy week already. The outcome between the Fed and the BOE could not be more different. The Federal Reserve cut interest rates and also indicated a rapid pace of rate cuts in the coming months. In contrast, there is virtually no chance of a rate cut later today from the Bank of England, and less than 30% chance of a cut by the end of this year.

UK: an outlier for the wrong reasons

If rates in the UK stay where they are, then we are set to have the highest interest rates in the G10, alongside one of the highest inflation rates in the G20. This is not an enviable spot to be in, especially when the Office for Budget Responsibility is set to downgrade its productivity estimates in time for the November budget, which would increase the hit to public finances.  

Inflation concerns bite

While a cut to interest rates would give a positive boost to British businesses and consumers, the BOE is likely to be focused on controlling inflation, and they are likely to maintain their view that interest rates need to be reduced in a ‘gradual and careful’ way. Headline CPI was as expected last month, and it suggests that disinflation has stalled in the UK. This is something that the BOE cannot ignore, since they have sole mandate to manage price stability.

The August CPI report showed price growth remained at 3.8%, the worrying aspect for the BOE is that the price increases were broad, there were no declines in any of the CPI categories last month. This has been the case in recent months and suggests that momentum for price growth is to the upside. The BOE, thus, needs to be on its guard when it comes to interest rates, as a premature loosening of monetary policy could ignite more inflationary pressure on the UK economy.

The interest rate futures market has remained convinced that there will only be one rate cut between now and mid-2026. We expect no change in rates tomorrow, and we think that the inflation backdrop means that most members, bar a couple of known doves, including Dhingra and Ramsden, will vote to keep rates on hold. The weakening labour market and growth picture do not support calls for rate hikes, in our view.

We doubt that the BOE will give much away about the future outlook for rates. The market has already priced out the prospect of another rate cut in November, so there is little that the BOE can do on rates that will surprise the market.

Quantitative Tightening scale back

More important will be the focus on quantitative tightening, the market is expecting the bank to reduce the amount of Gilts that it wants to offload from its balance sheet from £100bn a year to £70bn. This is designed to ease pressure on longer term yields in the UK, which have risen to a near 30-year high. But reducing QT is not without risk. The bonds on the BOE’s balance sheet have been losing value as bond prices have fallen, and yields have risen in recent years. In contrast, the amount that the BOE pays in interest on bank reserves has been rising, and the BOE has required Treasury transfers to manage this. Ultimately, this will be for the Chancellor to solve, and it could lead to bank taxes included in this Autumn’s budget.

The market reaction

The pound has had a middling performance over the past month. It has rallied vs. a weak dollar, however, gains have been mild, GBPUSD has risen by 0.9%. The pound has slipped by 0.3% vs the euro in recent weeks.

Pound strength has been held back by bond yields. UK bond yields have risen at a much slower pace than European yields in the last 3 months. The 10-year yield is higher by 7bps, the 2-year yield by 3bps, and the 30-year yield by 14bps. By recent standards, this is a moderate gain for UK yields and this justifies the low volatility in the pound.

We do not think that the BOE will want to upset the UK’s sensitive bond market, or to cause market concern about monetary policy, instead they are likely to commit to setting policy on a meeting-by-meeting basis, and they will also signal that they will not pre-commit to a policy path.

Aside from the changes to QT, this meeting is unlikely to be surprising for investors, and instead we think that markets will continue to react to the fallout from last night’s Fed meeting. We will be watching to see if the dollar can continue to rise, if Treasury yields will hold onto their recent gains, if the gold price will extend losses and where US stocks will go next, especially tech stocks.