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The BoE should cut interest rates, but gradually

Investment Insights • Macro Flash Note

2 min read

The BoE should cut interest rates, but gradually

The Bank of England’s Monetary Policy Committee (MPC) must deal with persistent inflationary pressures in the UK. Services prices and wage growth remain strong despite headline inflation returning close to the 2% target. This problem is shared by central bankers in many economies. In this Macro Flash Note, Chief Economist Stefan Gerlach and Economist Joaquin Thul look at the relation between these variables and the implications for monetary policy.

Stefan Gerlach
Stefan Gerlach

In her first speech as Deputy Governor for Monetary Policy at the Bank of England (BoE), Clare Lombardelli stated there are risks that UK inflation will be more persistent than expected. She noted that:

… there’s a risk that demand remains strong relative to supply so that inflationary pressures remain. A tight labour market would give workers more power in wage setting and resilient demand would enable firms to raise prices by more than would be consistent with inflation at target sustainably.1

These concerns about inflation and wages are shared by central bankers in other economies. This reflects a common pattern of headline inflation having declined sharply from its post-Covid peak, but services inflation and wage growth both remaining uncomfortably high.

Recently, the BoE has started to think of policy in terms of scenarios. The Bank’s Monetary Policy Summary for November 2024 spells out three scenarios:

  • Scenario 1 assumes that wage growth and inflation decline following the unwinding of the global shocks that drove up inflation. If the economy evolves in this way, monetary policy can be relaxed quickly.
  • Scenario 2 assumes that some economic slack is necessary for this process to be completed. Monetary policy then needs to be tighter for a little longer to ensure that inflation returns to target. This is the Bank’s main scenario.
  • Scenario 3 assumes that inflation persistence reflects deeper structural changes in wage and price-setting that require a longer period of restrictive monetary policy to prevent inflation expectations from drifting upward.

The chart below shows UK services inflation and wage growth, which the MPC views as good indicators of underlying price pressures.

Chart 1 – UK services inflation and wages growth

<p>UK services inflation and wages growth</p>

Source: LSEG Data & Analytics and EFGAM. Data as of 29 January 2025

An obvious interpretation is that high services price inflation reflects high wage growth since services are labour intensive. But that would be jumping to a conclusion. Much of macroeconomics deals with understanding the correlation between endogenous variables. The relationship between money growth and inflation is a case in point: supporters of monetary targeting often produced graphs like that above. But they merely highlighted correlation and did not settle the issue of causality.

The coincidence of above-average inflation and above-average wage growth can be interpreted in two ways. The competing interpretation is that high wage growth reflects the erosion of real wages caused by high past inflation, and workers’ desire to be compensated.

Indeed, recent work by economists at the US Federal Reserve suggest that this is also the case for the US economy. Research from the Boston Fed highlights that wages in the US are still catching up to the inflation shock after the covid pandemic.2  Additionally, a study from two former senior staff members at the Federal Reserve Board argue that lagged wage gains have not been good predictors of US inflation. They go on to state that “econometric evidence suggests that causality runs from prices to wages, though probably not from wages to prices”. 3 4  

Following the same methodology as the study from the Boston Fed described above, we estimate a VAR model for UK wages, services prices, unemployment, and productivity over the period from Q1-2001 to Q4-2019 and investigated the model’s forecasting performance in the period Q1-2020 to Q3-2024.

The results obtained show that wage growth has been unusually high, even considering the high rate of inflation. Furthermore, price increases have been unusually large, even considering the large wage increases. The simple story of wage growth causing inflation misses something. If anything, it looks like the overall level of demand was too high, leading both wage growth and inflation to be too high. Furthermore, the model overpredicts unemployment and productivity growth.  

Monetary policy implications

The pattern of forecast errors fit well with Deputy Governor Lombardelli’s description of the current UK economic situation: the labour market is tight, inflation and wage pressures remain strong, and the weakness of productivity growth suggests that adverse supply shocks have occurred. If so, the MPC might not find it advisable to cut interest rates rapidly in the spring, despite the decline in inflation in December.

Other factors also suggest a need to exercise caution when contemplating interest rate cuts: the weakness of sterling, concerns about the outlook for fiscal policy and the risk that the increase in employer National Insurance Contributions will push up costs and further stall the decline of inflation.

The MPC will communicate its decision on 6 February. Markets expect the BoE to cut rates by 25bps to 4.5% at their next meeting, and currently price-in one more rate cut in 2025. We await what their decision will signal about the outlook for interest rates going forward.

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