Bank of England: Interest Rate Cuts on Hold

On a Thursday evening, the Bank of England (BoE) announced its latest interest rate decision, revealing it would not proceed with cuts as many had anticipatedThe monetary policy meeting culminated in a split vote of 6-3, with the central bank opting to maintain the benchmark interest rate at 4.75%. This decision marks a significant moment in the context of ongoing economic challenges facing the UK.

In the monetary policy summary, the Bank of England stressed that the battle against inflation has not yet reached its conclusionThey articulated a firm stance, stating, “it is essential to efficiently and sustainably extract the remaining inflation pressures from the economy.” Regarding the future trajectory for interest rates, BoE officials indicated that “it remains appropriate to adopt a gradual approach to removing monetary policy restrictions.” This positioning indicates the central bank's cautious outlook amidst rising economic indicators.

One influencing factor on the BoE's cautious stance is the latest inflation resurgence within the UK

On Wednesday, the Office for National Statistics released data revealing that the Consumer Price Index (CPI) in November rose to 2.6%, up from 2.3% in October, marking an eight-month high and straying further from the government’s target of 2%.

With the Labour government's tax rise and spending budget set to take effect next year, there are widespread concerns that this may further fan the flames of inflation in the UKCompounding these worries, the British economy has contracted for two consecutive months, stirring memories of the “British disease” of stagflation from the 1970s, characterized by stagnant economic growth alongside high inflation.

Faced with rising inflation on one side and slowing economic growth on the other, the Bank of England must navigate increasingly difficult decisions

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The BoE’s decision to maintain the status quo marks a capstone to its monetary policy for 2024, while market expectations for potential rate cuts have been curtailed significantly from four anticipated cuts to just two, with the proposed reduction in rates falling from 70 basis points to 50 basis points.

A slower pace of interest rate cuts is likely to impede the UK’s economic recoveryChancellor of the Exchequer Rachel Reeves has frequently portrayed ambitious visions to stimulate economic growth, but the question remains—can these promises truly be fulfilled?

A resurgence of inflation

In October 2022, the UK saw a peak inflation rate of 11%, following which inflation had been on a downward trend

However, this trend has shown signs of reversal in recent monthsAccording to the data released by the Office for National Statistics on Wednesday, propelled by increases in fuel and clothing prices, the CPI for November reflected a year-on-year increase of 2.6%, the fastest rate of price increases observed since the first quarter of this year, and notably surpassing rates seen in France, Germany, and the United States.

The rally in inflation has understandably raised concerns in the marketLeading up to the BoE's latest meeting, UK gilt prices tumbled, and during Thursday's session, the yield on 10-year government bonds peaked at 4.651%, reaching its highest level since October 2023, before slightly retracting

Over the past week, the yield on 10-year gilts surged nearly 24 basis points, with the yield spread between British and German 10-year bonds wide, reaching a 229 basis point difference—the largest since 1990.

Li Yingting, an analyst at the Bank of China Research Institute, pointed out that the rebound in UK inflation in November can primarily be attributed to commodity inflation turning positive and persistent inflation in servicesFor November, the goods inflation in the UK shifted from a year-on-year decrease of 0.3% in October to a rise of 0.4%. Notably, the prices of alcohol and tobacco climbed by 6.9% year-on-year, a significant rise of 1.6 percentage points compared to OctoberSimultaneously, the inflation rate in the services sector remains high, registering a year-on-year increase of 5.0% in November, unchanged from October figures

Notably, increases in healthcare, communications, and education costs reached 5.5%, 5.0%, and 4.8%, respectively.

The inflation rate in the service industry serves as a critical reference point for the BoE's interest rate decisionsNonetheless, wage growth and the tight labor market pose challenges for the inflation control in this sectorThe latest data from the Office for National Statistics released earlier this week indicated that average regular wages had risen by 5.2% over the three months to October, exceeding expectationsMeanwhile, the unemployment rate remained stable at 4.3%, with job vacancies also above pre-pandemic levels, showcasing a persistently tight labor market in the UK.

Moreover, the greatest threat to the UK's inflation control comes from the Labour Party's recent autumn budget proposal

Chancellor Reeves's outlined fiscal budget entails significant increases in public spending, government debt, and a £26 billion tax hike, raising fears regarding inflationary pressures. 

The latest forecasts from the Bank of England in November suggest that the forthcoming budget will enhance economic growth by 0.75 percentage points over the next year, yet it will also exacerbate inflation by 0.5 percentage points, anticipating a near 3% inflation rate by the third quarter of next yearAn additional survey conducted by the BoE shows that households predict inflation will rise to 3% next year, marking the first increase in inflation expectations since 2023.

The specter of stagflation reemerges?

The UK is currently grappling not only with the resurgence of inflation but also with a looming recession threat as economic growth slows.

Recent data revealed that in October, the UK’s gross domestic product (GDP) paradoxically fell by 0.1% compared to the previous month, mirroring a similar decline in September

This marked the first occurrence of two consecutive months of economic contraction since the pandemic struck the country.

Moreover, over the period from October to November, the number of corporate bankruptcies surged by 13%, reaching 1,966—a figure that has drawn attention to the increasing financial instability within UK businessesThe UK's bankruptcy services noted that the average monthly number of bankruptcies in 2024 will match levels seen in 2023, a year that hit the highest bankruptcy figures since 1993.

With soaring prices combined with a sluggish economy, concerns are mounting that the UK may be on the verge of entering a familiar cycle of stagflation

Although current inflation levels pale in comparison to the extraordinary 24.2% witnessed in the 1970s, economists, such as Andrew Wishart from Berenberg Bank, contend that simultaneous inflation and economic growth troubles indicate a tangible risk of stagflation for the UK, particularly with recent data highlighting that this risk is intensifying.

Wang Wenguo, an analyst at Hong Yuan Futures Research Institute also pointed out that the Labour Party's introduction of a £100 billion fiscal stimulus plan drives consumer inflation expectations and hinders the prospects for swift interest rate cuts by the BoE, as their timing will lag behind the Federal Reserve and the European Central BankThis, in turn, poses a more pronounced risk of stagnation in UK economic growth.

The global implications of large countries reducing their deficits could push the UK economy into even more challenging predicaments

Wang further emphasized that beyond internal monetary and fiscal influences, anticipated tariffs could spark a decline in global trade, potentially compounded by austerity measures taken by the US and several EU member states, thereby intensifying the pressures on UK economic outcomes and reinforcing stagflation risks.

A slowdown in rate cuts next year

In early December, BoE Governor Andrew Bailey affirmed in a media interview that persisting price pressures and uncertainties in the cooling labor market may require a sustained tight monetary policy over the long haul

Yet, he indicated that the BoE may move toward four reductions of the benchmark rate in the coming year.

Jessica Hinds, an economist with Fitch Ratings, previously wrote to clients predicting that the BoE would lower interest rates quarterly throughout the next year, arriving at a benchmark rate of 3.75% by year-end.

However, in its latest monetary policy summary, the Bank of England stated that a gradual approach in easing monetary policy restrictions is still the way forwardThe monetary policy must remain restrictive long enough until inflation sustainably returns to the 2% target in the medium term.

This unequivocally dampens the optimism regarding those four rate cuts

Futures markets indicate that traders are now wagering on just two cuts next year, with an anticipated total reduction of only 46 basis points by the end of 2025, which is less than the previously expected 50 basis points.

This year, the Bank of England's approach to rate cuts has already lagged behind that of the European Central Bank and the Federal Reserve, and next year appears to continue the cautious, gradual descentEconomist Elliott Jordan-Doak from the Pantheon Macroeconomics Institute argued that the BoE is tasked with rebalancing between weak output and rising inflation, a balancing act that will necessitate a patient and measured approach to interest rate reductions.

Li Yingting concluded that the UK government's autumn budget will significantly influence future inflation trends