A rate-cut slowdown is on the cards

This time last year, there was relief all round that inflation (and with it the risk of stagflation) were disappearing out of sight in the rear-view mirror. Optimism about rate cuts and economic recovery was taking hold. One year on, however, and despite an apparent vanquishing of price growth and rate cuts being confidently counted off, an unsettling picture is forming: inflation has reappeared and is coming up fast on our tails, proving more stubborn than many expected. 

This is leading to a whole series of revisions to the prospective path for rate cuts this year. Certainly, clarity has been lost. The likelihood of the previously expected three to four reductions in 2025 is much decreased. Two cuts is now considered quite likely, with rates staying above 4 per cent into 2026. For some economists, the chance of a February cut now appears very slim.

However it is also apparent that the Bank of England (BoE) may be persuaded that the best course of action is to help revive the flatlining economy, in which case a faster pace of cuts may be possible.

In the most recent BoE meeting on 18 December, six members of the Monetary Policy Committee (MPC) voted to keep rates on hold in the face of rising inflation. Consumer price index (CPI) inflation notably jumped from 1.7 per cent in September to 2.6 per cent in November, in part the result of surging energy prices. More worrying are the gathering price rise catalysts, which include higher wage bills for employers and Trump tariffs. 

Although three members voted to take the rate to 4.5 per cent, no one was expecting the BoE to cut again so soon after its November decision to shave a quarter of a point off. Even so, its tone was wary, with references to uncertainties ahead and to inflationary pressures arising from the chancellor’s £25bn bill to employers and plan to increase the national living wage, as well as to geopolitical tensions and trade policy risks. The committee also looked at wage growth, noting that annual average weekly earnings had picked up sharply. The BoE’s own intelligence gathering suggests pay awards will be in the range of 3 to 4 per cent in 2025.

A jump in wage growth in particular is raising economists’ eyebrows: Bank of America points out that the month-on-month rise in October (at 0.77 per cent) was much higher than in the previous few months (average of 0.43). Berenberg thinks wage growth will be a bigger problem than the BoE expects. It argues a 3 to 4 per cent increase is not realistic given the twin drivers of minimum wage hikes and higher employer taxes, and concludes that the BoE will therefore “continue to be surprised to the upside by pay”. In fact, it says the most effective countermeasure would be to cancel the planned rise in the national living wage because the impact of this policy-driven rise in labour costs cannot be countered by monetary policy. 

As this currently seems unlikely, Berenberg’s view therefore is that the MPC will not be able to reduce interest rates by much – only twice more in its view – and will have to accept above-target inflation. 

But the wintery state of the economy might trump inflation fears, causing the BoE to worry less about high price growth and more about weak activity. After all, the Trump threat can be dismissed to an extent, and is in any case unlikely to be an immediate risk. And it’s not as though a 4.5 per cent base rate isn’t itself restrictive. 

Economic activity is undoubtedly weak. GDP declined in September and October, and manufacturing contracted by 0.6 per cent in October. The Confederation of British Industry has warned that the private sector is expecting a steep decline in activity in the first quarter, while the BoE’s own forecast for growth in Q4 now says it will be flat.  

Ruth Gregory at Capital Economics says these issues appear to be weighing increasingly on MPC members’ minds, and her view is that markets have gone too far in pricing in only a 45 per cent chance of a rate cut in February and just two 25 basis point rate cuts this year. 

Pantheon Macroeconomics comes down on the side of three cuts this year, and a 25 basis point cut in February, because if this is skipped, it says the long period between cuts would “stretch the definition of 'gradual'”. It sees a good case for steady monetary policy easing but acknowledges the MPC will have to be cautious “in the face of highly visible price rises”.