BoE to keep rates on hold tomorrow

Tomorrow’s interest rate decision from the Bank of England (BoE) is the very definition of a close call, the markets currently pricing in a 61% chance of a rate cut being delivered while others see it as close as 50/50. But while recognizing tomorrow’s vote could go either way, we continue to expect the Monetary Policy Committee (MPC) to keep rates on hold for one more meeting, our argument predicated on three things: the current strength of the UK economy, an insufficiently weak labour market, and stubbornly high services sector inflation.

Growth stronger than expected

The pace of growth seen so far this year has been considerably stronger than expected and, most importantly, has exceeded the BoE’s own forecasts. Indeed, so far this year, the monthly growth numbers have exceeded expectations each month, leaving the economy growing already in 2024 by 1.5%. And encouragingly, this growth is broad based, with only the construction sector lagging as it struggles with the wetter weather the UK has experienced this year.

And going forward, the signs are that this pace of growth is expected to continue, with the forward-looking PMI surveys showing activity expected to accelerate in all three of its reported metrics – the manufacturing, services, and composite readings. The latest PMI reports for July (https://www.equiti.com/sc-en/news/breaking-data/uk-pmi-surveys-raise-further-doubts-about-an-august-rate-cut/) showed a composite reading of 52.7, the highest print since October 2021, and clearly showing firms expecting output to accelerate further away from current levels. Of course, a significant driver of this above trend rate of growth could simply be the economy bouncing back more strongly than expected from last year’s recession, exhibiting a faster speed of recovery rather than sending any explicit message about the strength of growth to be expected over the medium term. But from the data delivered so far, it is hard not to conclude that the UK economy is performing more strongly than expected, an outcome that ordinarily you would expect to be accompanied by a higher level of interest rates (https://www.equiti.com/sc-en/news/breaking-data/latest-uk-labour-market-data-fails-to-open-the-door-further-on-an-august-rate-cut/).

Labour market still too strong

Secondly, the labour market remains too strong to justify a loosening in monetary policy (https://www.equiti.com/sc-en/news/breaking-data/latest-uk-labour-market-data-fails-to-open-the-door-further-on-an-august-rate-cut/). Although the headline rate of unemployment has been slowly edging upwards, rising to 4.4% in May, the payrolled employee numbers showed hirings increasing by 16k in June, with an upwards revision made to the May number of +57k. With June’s reading very much at risk of being revised higher also, these numbers do not suggest that demand for labour is materially weakening. Indeed, after showing a dip in hiring between February and April, the bounce now suggests that the earlier dips were simply a response to the 2023 H2 recession, and that as growth now recovers so hiring will similarly pick up. As such, the BoE may conclude that the labour is actually at risk of tightening again going forward, rather than weakening as it is seeking.

Equally worrying will be the wages growth numbers. Even though private sector average weekly earnings in May fell from 5.9% to 5.6% on a 3-mth annualized basis, wages growth of this magnitude remains too strong to be compatible with a 2% CPI target. And with the PMI survey data showing firms planning on boosting hiring, the outlook for wages growth looks anything but benign.

Services inflation too high

Thirdly, despite the headline rate of CPI (https://www.equiti.com/sc-en/news/breaking-data/uk-inflation-figures-further-reduce-the-prospects-of-an-august-interest-rate-cut/) falling back to its 2% target, core services inflation in June was 5.7%, nearly three times above target, and some 0.60% higher than the MPC’s May forecast. The fact that services inflation has remained so strong for so long suggests that it is deep-seated and embedded and cannot be explained away by any single, one-off, factors. Numerous MPC members have alluded to the need to bring services inflation down much closer to target before being willing to cut interest rates; the latest data will have done nothing to change their minds.

And going forward, inflationary pressures are expected to modestly strengthen. Energy prices are expected to be increase by 12% in October for all households on the default energy tariff (the majority), while food and non-energy goods prices, having already fallen sufficiently to converge with producer price inflation, can no longer exert further downwards pressure on CPI. When you consider that these two components alone have been almost entirely responsible for the falls seen in CPI since its peak in 2022, ensuring it now remains at its 2% target looks set to be challenging for the BoE, and is a battle that will almost certainly only be won if it can bring down the rate of services CPI.

Economic case to cut in August has not quite been made

Given all the above, we argue that the economic case for cutting interest rates in August is not as strong as the market is currently anticipating (61% chance). However, the minutes from the June meeting suggested that the MPC is desperate to cut rates and that the decision not to cut them was closer than the voting count suggested (7-2). The take-away from this is that the MPC’s tolerance for data misses is higher than what might be expected and that it is therefore prepared to overlook all of the above points if that is required for it to deliver a cut. And forecasting tomorrow’s decision is not made any easier by the fact that there is a new member on the MPC - Clare Lombardelli – who replaces Ben Broadbent (a hawk), and who is yet to reveal her colours as either a ‘hawk’ or a ‘dove.’

Conclusion

Our base scenario remains that the August MPC meeting will deliver a decision to keep interest rates on hold at 5.25%. We suggest there is no smoking gun to be found that is calling for rates to be cut yet, while loosening monetary policy when pricing pressures in the largest sector of your economy are growing at 5.7% looks optically difficult. But thereafter, the pressure to cut rates will be too strong for the MPC to push back against, and we accordingly expect a 25bps cut to be delivered at both the September and December MPC meetings.