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IF Insights: Will BoE react to plummeting UK inflation with rate cuts?

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Compared to other large, wealthy economies, Britain's inflation rate peaked higher

The Bank of England’s 2% target for the inflation rate in Britain appears to be within reach. Latest data shows that the price rise in the European nation cooled to its lowest level in nearly three years in April 2024, driven by big declines in domestic bills, suggesting that the cost-of-living crunch, which since 2022, has been crippling the overall British economy and common citizens, is now finally receding.

Will it help the incumbent Rishi Sunak government to win the general elections later this year? This copy won’t discuss about the political fallouts of the UK inflation, as all the eyes will be upon the Bank of England. Will the apex bank cut down the interest rates?

Falling energy prices, which are out of the BoE’s control, are contributing to the decline in headline consumer price inflation, which peaked at 11.1% a year and a half ago. Inflation, as measured by the consumer prices index (CPI), has now fallen to 2.3% in the year to April 2024, down from 3.2% in March. The April figure is the lowest level since July 2021, when the global economy was handcuffed by the COVID-19 pandemic.

The price pressures created by the British economy are of greater importance to its policymakers, particularly given the country’s tight labour market and the high rate at which many companies are raising wages, which might end up fueling inflation yet again.

According to BoE Governor Andrew Bailey, depending on the facts, the first rate cut might occur as early as June 2024. However, as per a section of the analysts, despite the sharp decline, the latest inflation gauge may have dashed market expectations of a deeper slowdown to 2.1%. So the BoE may likely wait till July to study the May data and figure out whether things are actually touching the 2% mark, a non-negotiable condition imposed by the BoE for their monetary policy relaxations.

However, there are chances that after the publication of the latest CPI data, BoE’s nine-member rate-setting panel may give in to the market pressure of cutting interest rates from the current 16-year high of 5.25%.

Where Are Things Standing Now?

Compared to other large, wealthy economies, Britain’s inflation rate peaked higher. A combination of the spike in energy prices and a labour scarcity to fill positions, a problem already present in other nations but made worse in Britain by Brexit, made it an anomaly among the Group of Seven (G7) for a while.

Inflation in Britain was 3.2% in the year ending in March 2024, which was greater than that of Germany, France, and Italy. However, it was less than 3.5% in the United States.

However, the latest CPI data might have dashed the economists’ hope of witnessing a sharper drop in inflation after a 12% drop in regulated household energy tariffs that took effect in April 2024.

According to Reuters polled economists, they were expecting headline inflation to abruptly fall to 2.1%, before starting the probable ascent again in the latter half of 2024. Even BoE expects the inflation to pick up speed once again, reaching about 2.6% by year-end.

“This is only one month’s data, but it is enough of a surprise to suggest that the inflation process is not tracking as the BoE had expected,” Allan Monks, chief UK economist at JPMorgan, said, while interacting with the Daily Sabah.

“There is still another labour market and CPI report to come before the June meeting, but it is difficult for us to see what that could realistically do to leave most members feeling confident about cutting in June specifically,” Monks added further.

Services inflation inched down to 5.9% from 6% in March 2024. The BoE’s forecasts had pointed to a reading of 5.5%.

Market Pressures For Labour

Wages account for a larger portion of costs for services firms than for other businesses. Because there is a greater need for workers to fill positions than in many other economies, Britain has had an annual pay growth rate of 6%, which has increased prices in the industry.

There are some indications lately that the fever in the labour market is dissipating. The gap between the number of open positions and the unemployment rate—a crucial indicator of the Bank of England—is at its tightest point since the COVID-19 epidemic.

Companies Struggle To Raise Prices

The potential for businesses to pass on increased expenses to customers in the form of higher pricing is another item the BoE is keeping a careful eye on. Regional agents for the BoE predict that this year will be more difficult than 2024.

One of the nine members of the Monetary Policy Committee, Megan Greene, cited comparable indicators from the recent purchasing manager index reports, indicating that prices paid by businesses have increased more rapidly than the prices they charge.

Will The Rate Cut Happen?

June 11 is the official labour market data release, June 19 is the publication of May’s inflation data, and June 20 is the next scheduled policy announcement by the BoE. The BoE will be keeping a closer eye on alternative market indicators than normal due to issues with the official jobs statistics, such as the PMI surveys.

Rate futures are priced with an approximately 56% probability of the Bank of England reducing the Bank Rate to 5% from 5.25% in the upcoming days, and an almost 100% possibility of a reduction by the meeting in August 2024.

The date of the BoE’s first move was also a topic of debate among the 71 economists surveyed by Reuters recently. However, a slim majority of them anticipated it to happen later than investors do: 38 predicted a first cut in August, while 31 suggested June. September is when two people expected it to arrive.

However, analysts at RBC Capital gave a pessimistic view, stating that the overshoot in services inflation did not appear to be driven by one-off factors, suggesting that the much-anticipated rate cut may take some more time.

“Certainly, this morning takes June off the table,” Cathal Kennedy, senior UK economist at RBC Capital Markets, said, while adding, “We’ve been saying for some time that we thought services inflation would be a lot harder to get down than perhaps some other people out there thought, particularly with the backdrop of the U.K. labour market, which has loosened but is still very, very tight.”

“Core inflation, which includes goods but not energy, food and tobacco, also reflected persistent price pressures, with the annual rate falling only to 3.9% from 4.2% in March 2024,” Daily Sabah reported further.

The next rate meeting is on June 20, and economists are a divided lot on what will happen on that day. Some think that the apex bank will cut borrowing costs. However, others believe that the ongoing concerns over the scale of price rises in the crucial services sector, along with the pace of wage increases, will make the rate cut a likely phenomenon from August 2024.

Also, lower inflation doesn’t mean that the cost of living crisis (the worst in around 40 years) is finally over. Things only show that the prices are rising more slowly than they were before.

“Consumers are still living with far higher prices and how you take today’s inflation data will depend on whether your glass is half full or half empty,” said James Smith, research director at the Resolution Foundation.

“While it’s clearly good news headline inflation is back to normal levels, it is disappointing that price pressures haven’t fallen further and that measures of services inflation are proving more stubborn than expected,” he concluded.

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