Bank of England: Easy decision made but trickier ones ahead

Executive summary:

• The Bank of England (BoE) cut its key interest rate from 4.75% to 4.50% in a 7-2 decision. The decision was unanimously expected by economists and traders, but Catherine Mann’s joining the dovish camp was a shock.
• Greater challenges await in future meetings when the BoE will be balancing the need to support an ailing economy without reigniting inflationary pressures.
• We think that the BoE could reduce rates more this year than the additional 65 basis points currently priced in money markets.
• Higher gilt yields are a challenge for the government but may be used by some pension funds to lower their risk by narrowing the range of possible funding ratio outcomes.

Today, the BoE’s Monetary Policy Committee (MPC) lowered the bank rate from 4.75% to 4.50%. The decision was not a surprise¹, but the vote was. 

A majority of 7 to 2 committee members opted for the 25 basis point move. The two dissenting members, Swati Dhingra and Catherine Mann, preferred a 50 basis point cut. Economists polled by Reuters had expected an 8 to 1 vote.

The switch of Catherine Mann to the dovish camp was a shock since she long had been considered the most hawkish MPC member. At the previous meeting in December, the MPC had voted 6 to 3 to hold rates steady, with Mann among those voting to keep rates unchanged. 

After the vote shock, traders were anxiously waiting for the press conference and the forward guidance given by Governor Andrew Bailey. The MPC is sticking to a gradual approach in its rate policy, given the two-sided risks to inflation. The committee is choosing flexibility over pre-commitment, relying on incoming data to assess whether sticky inflation or flagging growth is the greater risk.

Several regulated price adjustments and tax changes kick in over the coming months, affecting households and businesses and clouding the inflation outlook for the BoE. The energy price cap, which sets the maximum gas and electricity rates that utilities can charge consumers, is projected to rise by 3% to 6% from April 2025, bringing the average annual bill for a typical household to between £1,796 and £1,848².

For businesses, the cost of labor will also rise from April 2025, due to an increase in the national living wage (NLW) from £11.44 to £12.21 per hour. Additionally, national insurance contributions (NIC) paid by employers are set to rise by 1.2 percentage points. 

The 6.7% hike in the NLW is a welcome boost to the earnings of low-income workers, but together with the NIC increase, could impart a near-term inflationary impulse if businesses try to pass on their higher input costs to consumer prices. Over time, NLW and NIC increases will likely dampen companies’ demand for labor, reducing employment and wage growth. 

Like in other countries, GDP in the UK slumped during the Covid pandemic of 2020. While GDP reclaimed its pre-pandemic level swiftly in 2021, as we see in the chart below, UK growth has largely flatlined since 2022.  Sluggish business investment and the drag from international trade are the main culprits. Britain faced structural headwinds that other nations did not have to contend with; for example, the trade disruptions from Brexit, which added to the Covid and energy price shocks following Russia’s invasion of Ukraine. Despite stagnating growth, the BoE embarked on an aggressive hiking cycle in 2021-23 to contain surging inflation. 

 UK cumulative GDP growth since 2020

Making policy in a “stagflation” environment with high inflation and lackluster growth is a formidable challenge. Unlike the Federal Reserve, which can take its time with rate cuts given a resilient U.S. economy, or the European Central Bank, which is slated to plough ahead with its easing cycle amid falling inflation and growth weakness, the BoE is on difficult middle ground. Tax hikes and rises in administered prices will at least temporarily increase price pressures. The balance between the inflationary impulse and a slackening jobs market will determine the pace of further rate cuts in 2025. 

A taste of stagflation came through in the BoE’s revised economic projections relative to the November monetary policy report. Significant upward revisions to the unemployment rate across the forecast horizon combined with a near-term pick-up in inflation make for a discouraging backdrop, but we expect that disinflationary pressures will dominate toward the end of the 3-year forecast period. We think that the BoE could reduce rates more this year than the additional 65 basis points currently priced in money markets.

With the vote showing an unexpected dovish shift in the MPC, the gilt curve steepened. Immediately after the decision, 2-year yields dropped by 7 basis points and 10-year yields fell by 4 basis points but have since rebounded. In foreign exchange markets, the pound sterling (GBP) slumped by around 1% vis-à-vis the U.S. dollar.

Stepping back from today’s price action, long-term interest rates in the UK have risen sharply along with global bond yields since the U.S. election in November 2024 (see chart below). In mid-January, nominal 20-year gilt yields rose above 5.4%, a 27-year high. Real 20-year gilt yields derived from inflation-linked bonds briefly touched 2%, a level not seen for the last 20 years and exceeding the spike during 2022 mini-budget crisis. Our own valuation models show that UK government bonds are attractively valued, and UK yields have room to fall. As we wrote in a previous article, higher gilt yields are a challenge for the government, but may be used by some pension funds to lower their risk by narrowing the range of possible funding ratio outcomes.

The BoE cut its key interest rate from 4.75% to 4.50% today in a 7-2 decision. The decision was unanimously expected by economists and traders, but Catherine Mann’s joining of the dovish camp was a shock. Greater challenges await in future meetings when the BoE will be balancing the need to support an ailing economy without reigniting inflationary pressures. Increases in taxes and regulated prices in the spring will make it difficult to separate signal from noise. If rate cuts prove too shallow or too slow, economic stagnation could persist. However, the bank is still wary of undoing its hard-won credibility in fighting inflation if it lowers rates too quickly. 

Today’s decision was easy, future meetings will be a lot trickier. Catherine Mann’s transformation from hawk to dove today was a precursor of that.

¹ All 65 economists surveyed by Reuters had predicted the cut and money market traders had been almost 100% confident of the move

²  https://www.moneysavingexpert.com/utilities/energy-price-cap-prediction/