Diverging Views on UK Interest Rate Decisions

The market widely expects the Bank of England (BoE) to cut its key interest rate from 4.25% to 4% this week, with further cuts anticipated before the end of the year. However, this expectation comes against a backdrop of consumer price inflation having risen in June to almost double the BoE's 2% target.

But policymakers are divided on several issues: first, how much underlying price pressures have actually eased; and second, whether a slowing labor market and sluggish economic growth will cause inflation to undershoot the target in the medium term without further interest rate cuts.

Following the Russia-Ukraine conflict in 2022, UK inflation surged by more than in the Eurozone or the US, peaking at 11.1%, partly due to the UK's heavy reliance on natural gas for heating and electricity. Inflation fell sharply in 2023 and bottomed out at 1.7% in September 2024. But since then, its rebound has accelerated at a faster pace than in the US or the Eurozone, and the BoE forecast in May that inflation would not return to its target until early 2027. June inflation rose to 3.6%, its highest level since January 2024, and some economists believe it will soon reach 4%. By comparison, the European Central Bank expects Eurozone inflation to hover at just under 2%.

Rising Inflation Expectations

Most BoE officials regard surveys of companies' and households' expectations for future inflation as an important guide to future price increases and wage demands, and even as a measure of central bank credibility. These indicators have crept up in the past year. The Citi/YouGov measure of long-term inflation expectations is close to its highest level since late 2022 - when overall inflation was still in double digits, and the BoE's own survey is also at its highest level since 2019.

However, some officials place less weight on these surveys, believing that respondents' answers are simply a reaction to recent inflation rather than a prediction of future behavior.

Persistent Domestic Inflation

Although overall consumer inflation has begun to pick up again after a sharp fall in 2023, two components often used as a measure of longer-term domestic price pressures have not seen the same degree of decline. Services price inflation, heavily influenced by increased labor costs, and core CPI have both remained higher than overall inflation.

Additionally, food and beverage price inflation has begun to pick up rapidly, which has a big impact on the public's perception of inflation, especially for poorer UK citizens.

Wage Growth High but Slowing

Currently, private sector annual regular wage growth is just under 5%, having fallen back from a peak of over 8% two years ago. But this is still about 2 percentage points higher than before the Covid-19 pandemic, and also higher than the roughly 3% that most policymakers consider to be consistent with the 2% inflation target. The central bank itself, and employers it surveys, expect wage growth to slow further to around 3% in the next 18 months, putting downward pressure on inflation. But the decline in wage growth has not been smooth in the past year, and rising unemployment and falling job vacancies do not guarantee that wage growth will slow as quickly as the BoE expects.

PMI Data Suggests Rising Cost Pressures

July's purchasing managers' index (PMI) data showed that UK companies are raising prices at a "very strong" pace, according to S&P Global, which compiles the monthly data. Although down from 2022, the survey still shows bigger price rises than before the pandemic. Over the past year, costs have risen sharply for both services companies and manufacturers - and if these costs are passed on to consumers, they will put upward pressure on prices.