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Doves on the Bank of England’s Monetary Policy Committee prevailed by a hair’s breadth this week, winning a vote to cut interest rates for the first time since the start of the Covid-19 pandemic.
But the narrow five-to-four decision reflects two sharply contrasting views of the world, held by opposing camps on the nine-member panel.
As the central bank’s governor Andrew Bailey made clear, the pace and scale of any further rate cuts will depend on which of these scenarios turns out to be more accurate.
“We need to make sure that inflation stays low . . . and we need to be careful not to cut rates too much or too quickly,” Andrew Bailey told a press conference following the policy decision on Thursday.
He shared the majority view on the MPC that a sustainable drop in inflation to the BoE’s 2 per cent target was “almost baked in” as global price shocks unwound. This might also still “require a period with economic slack in the UK economy”, he said.
For this group on the panel, the prospect of inflation rising back to 2.75 per cent in the near term, as energy prices stabilised, was not a big worry.
Headline inflation would still be low enough to lessen wage and price pressures, the labour market would weaken further, and GDP growth was unlikely to remain as strong as it had proved earlier in the year, they argued.
Even at 5 per cent, interest rates would still be high enough to hurt and would continue squeezing inflationary pressures out of the system.
This relatively benign view underpins the BoE’s new forecasts for how it thinks the UK economy is most likely to evolve — with inflation falling to 1.7 per cent in two years’ time, if it cuts rates once more this year, as markets expect, reducing them to 3.5 per cent by 2027.
But Bailey pointed to “an alternative account of the economy, which is less benign”, where “inflationary pressures have become more ingrained . . . as a lasting legacy of the major shocks we have experienced”.
The more hawkish contingent on the MPC, including BoE chief economist Huw Pill, thinks this scenario is more likely to be true, and that it will “require monetary policy to remain tighter for longer”.
For the four MPC members who voted to leave rates unchanged, services inflation and wage growth were still too strong for comfort and headline inflation had come down largely because of external factors — such as global food and energy prices.
They saw a greater risk that the economy had undergone “more enduring structural shifts”, which meant it could not grow as fast or sustain as many jobs as in the past without inflation running amok.
It was also possible that recent strength in GDP growth would persist, adding to upward price pressures.
These risks mean that the quarter-point cut in borrowing costs — from 5.25 per cent to 5 per cent — should be seen only a tentative first move, not the start of a pre-determined series of rate cuts, the MPC warned.
“It is now appropriate to reduce slightly the degree of policy restrictiveness,” its minutes said.
The committee added that its stance “would need to continue to remain restrictive for sufficiently long until the risks — to inflation returning sustainably to the 2 per cent target in the medium term — had dissipated further”.
In a significant change in guidance, the MPC dropped wording on the importance of data releases on wage growth and service prices, and said it was continuing to “monitor closely the risks of inflation persistence”.
“I’m not giving you any view on the path of rates to come. We will go from meeting to meeting,” Bailey told the press conference.
One uncertainty the MPC is contending with is the ongoing lack of reliable official labour market data. The BoE said it was “very difficult” to gauge how the jobs market was evolving, with its own analysis pointing to lower unemployment and higher workforce participation than official estimates.
Another question is how far the impact of high interest rates has already been felt across the economy, and how much is still feeding through. The BoE published analysis suggesting that the effect on GDP growth might be both smaller and swifter than in the past — and so already receding.
On top of these uncertainties, the BoE will need to wait until its November meeting before it can assess any change in the direction of fiscal policy from the new Labour government.
Bailey said public sector pay deals announced earlier this week would have only a “very small” effect on the inflation outlook, and that the impact of other policy changes would depend on how they were funded. “The next step in this process is the Budget on October 30,” he said.
Analysts said these uncertainties, the hawkish tone of the MPC’s commentary, and the upside risks it highlighted to its central inflation forecast, left the policy outlook highly ambiguous.
Ruth Gregory, at the consultancy Capital Economics, said the BoE looked “in no rush to cut again”; while other analysts described the MPC’s guidance as “cautious” and “non-committal”.
“In the end, the sense of optimism prevailed — just . . . That is not to say that the rate cycle that is coming will be steep, speedy, or indeed return rates to where they were before Covid,” said Ellie Henderson, an economist at Investec.