Inflation is tamed at last – when will interest rates fall?

UK inflation may have hit the Bank of England target but it's unlikely to stay that way for long. What does that mean for interest rates?

Bank of England Building Abstract Art Design
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The UK has “won the race” in getting headline inflation back to target, says Sanjay Raja of Deutsche Bank. The annual rate of inflation hit the Bank of England’s (BoE’s) 2% price target in May for the first time since 2021. By contrast, US and Euro area inflation are running at 3.3% and 2.6% respectively. 

The return to target has been helped along by falling goods prices (down an average of 1.3% over the past year) thanks to cooler food-price inflation and falling household energy tariffs. Yet the “fly in the ointment” remains stubborn price rises in the services sector, where inflation is still running at 5.7% year-on-year as high wage costs bite (average UK pay rose 6% in the year to February-April, excluding bonuses). The bad news is that UK inflation is thus unlikely to stay at 2% for long and looks likely to average 2.5% in the second half of the year.

Interest rate cuts are coming

Cooler inflation should open the door to interest rate cuts, but not straight away. Last week the BoE’s monetary policy committee again voted to hold interest rates at 5.25%. Seven committee members opted to hold, with two supporting a cut. 

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The minutes of the meeting marked “a significant change in tone” for the Bank, say Dearbail Jordan and Faisal Islam for the BBC. “While not a done deal”, Threadneedle Street has sent “a clear signal to the markets” that “a rate cut is now the most likely outcome at its next meeting” in August. It would thus join the European and Swiss Central Banks, which have already begun cutting rates. 

At 5.7%, annual services inflation is still running at about twice the level consistent with inflation remaining at the 2% target, says Chris Dorrell for City AM. Given that obstacle, investors were “pleasantly surprised” by the Bank’s “relatively dovish tone” at the meeting (easier money is usually good news for markets). Policymakers noted that a near 10% increase in the minimum wage this spring contributed to services inflation, but that future rises are unlikely to have such a big impact. 

Stretched homeowners will ask why the Bank is not already cutting borrowing costs. For one thing, slashing rates shortly before a general election would have been a bad look politically, not least because of Rishi Sunak’s attempt to claim credit for falling inflation, says David Smith in The Sunday Times. High services inflation also remains a genuine concern because “it is the closest thing we have to a measure of domestically generated inflation”. 

Still, the big picture is that rates are “coming down” – whether the first cut comes in August or September. Rejoice, “better times lie ahead” for the economy. Not that those improvements will come in time to help the government – whose idea was it to call an early election?

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