More interest rate cuts should be on the way

The Bank of England finally cut interest rates this week. With inflation now set to fall below target, further cuts should follow.

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Aug 04, 2024

This week the Bank of England’s Monetary Policy Committee (MPC) voted to cut the UK base rate by a quarter point, to 5%. This was a close call, but surely the right one.

Here, some would argue that we should focus on the quantity of money, rather than one single measure of its price. Others insist that central banks should not be setting interest rates at all. Instead, this should be left to the forces of supply and demand, with the markets free to determine the optimal rates that balance saving with borrowing and investment.

Both points have merit. Too little attention is paid to trends in broad money and credit, or to the impact of the Bank’s policy of ‘quantitative easing’ and (now) ‘quantitative tightening’ (QT). After all, it was the burst of money creation during the pandemic that led to the surge in inflation.

But we are where we are. The MPC – as well as investors, businesses, and consumers – all regard the Bank’s official interest rate as the main policy tool. It would be odd for others not to have any view on what that rate should be.

The obvious starting point is that CPI inflation has now been at or very close to the MPC’s 2% target for three successive months. This was perhaps a necessary but not sufficient condition for a rate cut.

More importantly, the Bank’s own forecasts point the way. Inflation is expected to pick up temporarily in the second half of this year, but then be back at or below the 2% target over the medium term even on the basis of market expectations that rates will be cut to 4¼% in one year and 3½% in two.

In the meantime, even at 5%, interest rates are well above the ‘neutral’ level and, therefore, will continue to bear down on inflation, especially as the Bank is persisting with QT as well. This ‘neutral’ level is perhaps 4% for nominal rates, based on 2% inflation and 2% real economic growth.

The fact that policy is still restrictive is part of the answer to those saying, ‘what about services inflation’? This is indeed still well above 2% (stuck at 5.7% in June). Another is that leading indicators of inflation point to easing price pressures in the services sector (including expectations for wages and for inflation itself).

Above all, money growth has now normalised. Broad money (M4) is expanding at an annualised rate of about 4% to 5%, which is a comfortable pace.

When will the MPC cut again? There is a strong case to keep going - ¼ point cuts at the remaining three meetings in September, November and December would take rates from the current 5% to 4¼% by year-end, then to 4% in early 2025.

But the hawkish tone of the minutes, and the cautious comments from the Governor, suggest the MPC might move more slowly (mirroring the ECB, which has also paused after a first cut back in June as euro area inflation has edged up again).

In particular, waiting until November would allow the MPC to assess the next quarterly set of economic forecasts. This would also allow the MPC to digest the October Budget and find out how the above-inflation public sector pay rises will be financed (in other words, how big the expected tax hikes will be). An alternative scenario might therefore see just one or two more cuts this year, to 4½-4¾%, though we should still get to 4% in 2025.

Alongside a continuation of the current steady pace of money growth, this should keep inflation close to target and support a sustained recovery in economic activity – without the problems stored up during the long period when monetary policy was far too loose.

Julian Jessop
Economics Fellow

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Bank of England finally cuts interest rates to 5% in first drop since 2020, Julian quoted in The Daily Express, The Daily Telegraph, The Daily Mail & Proactive

Cut interest rates immediately, says IEA’s Shadow Monetary Policy Committee

Inflation is long past its peak, Shadow Monetary Policy Committee Chair Andrew Lilico, Times Radio

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