Why the Bank of England has finally cut rates – but might not rush to do it again

Threadneedle Street’s decision to cut rates comes in spite of persistent price pressures

This is the most cautious rate cut the Bank of England could possibly have made.
Five members of the Monetary Policy Committee (MPC), including Andrew Bailey, the Governor, voted to cut rates to 5pc. The other four, including Huw Pill, chief economist, wanted to hold at 5.25pc, the level to which they raised borrowing costs last August.
Since the Old Lady of Threadneedle Street was granted independence to set rates in 1997, it has never held borrowing costs at the peak for longer than this.
Bailey and his colleagues want to send a signal to borrowers that they should not expect rates to be cut at every meeting. Unlike the rapid rise in interest rates during the cost of living crisis, the decline will be much slower.
Markets, however, were jubilant, with traders betting more heavily on further cuts this year.
The decision was on a knife-edge as the policymakers, whose job is to keep inflation at 2pc, are worried that price rises are not yet comprehensively vanquished.
“The job of monetary policy is to squeeze the persistent element of inflation out of the system in a way that is consistent with returning inflation to target on a timely and sustained basis. That is what we did by increasing Bank Rate to 5.25pc and keeping it at that level for a year,” said Bailey.
That has helped push inflation down when the pandemic and the energy price crisis threatened to set off a wage-price spiral in the UK.
He added: “But we still face the question of whether the persistent element of inflation is on course to decline to a level consistent with inflation being on target on a sustained basis and what it will take to make that happen.”
Headline consumer price rises have slowed to 2pc, bang on target, down from 2022’s peak of 11.1pc.
On the face of things, that allows the MPC to declare their mission accomplished – but much of the fall was driven by a decline in energy prices, and there are still dangerous pressures lurking under the surface.
Key to this are services price inflation and core inflation, which strips out energy and food costs.
Both are rising by significantly more than the 2pc headline target.
Services prices in particular are increasingly driven by wages.
Pay growth in the private sector has slowed from last year’s peak of more than 8pc, but at 5.6pc in May it is still well above levels officials consider consistent with inflation of 2pc. It raises the prospect that bosses will have to keep raising prices to afford those pay rises.
“Pay growth has become an increasingly important driver of the remaining strength in services inflation,” says the Bank’s Monetary Policy Report.
The MPC hopes this will keep on easing as lower inflation reduces the pressure on workers to demand big pay rises.
“The Committee expects the fall in headline inflation, and the normalisation in many indicators of inflation expectations, to continue to feed through to weaker pay and price-setting dynamics,” said the minutes of the MPC’s meeting.
Although the economy has grown more strongly than the Bank expected in the first half of the year, there are signs the jobs market is cooling, which would be expected to pull down pay growth.
Unemployment has edged up, and the number of vacancies advertised by employers has kept on falling.
The Office for National Statistics found 889,000 jobs were available in the three months to June, down from a peak of 1.3m two years ago and almost back to levels common before the pandemic, when interest rates were far lower.
On top of that, business surveys indicate bosses are cautious on hiring.
Hence the cautious rate cut: inflationary pressures are still menacing the economy, but they are weaker than they were six months ago.
The Bank thinks 5pc is still a restrictive rate, slowing the economy and taking the wind out of inflation – the cut from 5.25pc is akin to a driver easing off the brake pedal a little, rather than pressing down on the accelerator.
Mortgage rates on offer to borrowers are still two to three times as high as they were in late 2021. Even with a modest rate cut, anyone with a cheap fixed rate loan from before 2022 will still face a huge leap in their borrowing costs when they have to remortgage.
It means rates will still drain spending power from those households, slowing the economy and inflation for some time to come.
One of the biggest difficulties for Bailey and his colleagues is that it takes time for interest rates to feed through the economy and affect the rate of inflation. This lag is often thought to be around two years. It means they have to act through this year’s fog of uncertainty.
Price rises are set to pick up again to an estimated 2.75pc later this year – something which rates set today will not affect.
The minority of four MPC members, who voted to hold rates at 5.25pc, are worried that this, combined with high pay growth, is a sign inflation is not yet completely under control.
As a result, they want to keep rates high as they await more proof that it is time to cut.
“Underlying domestic inflationary pressures appeared more entrenched” to those four, the minutes say, with fears of “more enduring structural shifts”.
“They preferred to maintain the current level of bank rate [at 5.25pc] until there was stronger evidence that these upside pressures would not materialise,” the minutes add.
But the remaining five think they might be wrong. They voted to cut rates as “there has been some progress in moderating risks of persistence in inflation”.
The Bank’s forecasts indicate that if interest rates are held at 5pc for several years to come,  the economy will grind almost to a halt over the next year, unemployment will surge close to 6pc by 2027 and inflation will plunge to 1pc, just half the 1pc target.
However, if rates are cut as financial markets expect, dropping to 3.75pc by the end of 2026, the economy is forecast to fare better, unemployment will stay below 5pc and inflation will fall only to 1.8pc.
If anything, even this projection of inflation at a touch below the 2pc target suggests rates should be cut a little further than 3.75pc.
Confidence in those projections is clearly lacking. As well as worries over the persistence of inflation, the Bank also fears it is trying to set policy in the dark because of the poor quality of jobs data.
The Office for National Statistics has struggled to persuade more members of the public to complete its jobs surveys, making it hard to work out exactly how many people are in work or unemployed.
Those surveys indicate that a growing share of working-age adults have dropped out and are neither in a job nor looking to get one. The Bank notes that just under 63pc of adults are participating in the workforce, whether employed or unemployed – a definition which requires them to be seeking work and able to start a job. That is close to the lowest share since 1998.
It means that even if vacancies have fallen, the jobs market might be tighter than it appears, raising worries that bosses will have to offer higher pay as they fight to hire from the shrinking pool of people who are willing and able to work.
In turn that risks sustaining inflation for longer, requiring rates to stay high, or at least fall only very slowly.
That is why the Bank is groping in the dark towards lower rates.