The Bank of England has reduced interest rates by 25 basis points, indicating a “gradual” approach as the Budget’s impact permeates the economy.
Eight members of the Bank’s Monetary Policy Committee (MPC) voted in favour of the second rate cut this year, with only Catherine Mann opposing.
This brings the benchmark Bank Rate to 4.75 per cent, down from a high of 5.25 per cent. The Bank made its first interest rate cut since the pandemic in August.
Market expectations were met with this decision due to recent progress on inflation. Data released last month revealed that the headline rate dropped to 1.7 per cent in September, the lowest since April 2021.
Underlying inflation indicators, such as services inflation and wage growth, have also continued to ease, suggesting a decrease in domestic price pressures, as reported by City AM.
“If the economy evolves as we expect it’s likely that interest rates will continue to fall gradually from here,” stated Andrew Bailey, Governor of the Bank.
However, Bailey emphasised that the Bank “can’t cut interest rates too quickly or by too much” due to ongoing worries about inflationary dynamics.
Specifically, the Bank highlighted the potential inflationary effects of the new government’s inaugural Budget.
Chancellor Rachel Reeves unveiled approximately £40bn in tax hikes last week, which are set to underpin a £70bn average annual increase in government spending. According to the Bank’s latest projections, this blend of tax increases and heightened expenditure is expected to elevate inflation while simultaneously stimulating growth.
The Bank’s officials have estimated that due to the Budget’s implications, inflation could rise by about half a percentage point, potentially reaching a peak of 2.75% in mid-2025.
They anticipate that inflation will realign with its target by early 2027, which is roughly a year beyond their previous predictions.
The report also highlighted uncertainties surrounding the inflationary effects of the rise in employers’ national insurance contributions.
Bank of England warns on Budget fallout
Bank experts indicated significant ambiguity regarding the impact of the tax increments, noting that outcomes would hinge on “the degree and speed with which these higher costs pass through into prices, profit margins, wages and employment”.
In contrast to the Office for Budget Responsibility’s outlook, the Bank foresees businesses absorbing a larger portion of the increased expenses within their profit margins, rather than reducing employee wages.
Nonetheless, it was implied that the fiscal measures would likely lead to a “small decrease in potential supply” and exert a “small upward impact on inflation”.
Furthermore, the Bank suggested that the Budget would bolster growth by about 0.75% relative to the forecasts made in August. This adjustment could see the annual growth rate in 2025 surge to 1.75%, an increase from the current year’s projection of around one percent.
“This reflects the stronger, and relatively front-loaded, paths for government consumption and investment more than offsetting the impact on growth of higher taxes,” stated the Bank.
Growth is then projected to decline to 1.1 per cent in 2026 as a degree of spare capacity builds in the economy. This mirrors both the restrictive stance of monetary policy and fiscal tightening.
The forecasts were predicated on the assumption that the Bank Rate would drop to around 3.75 per cent by the end of next year.
Traders have already adjusted their expectations for rate cuts as a result of the Budget, anticipating just two or three rate cuts in 2025.
Setting aside the potential inflationary impacts of the Budget, Bank officials continued to highlight concerns about the persistence of services inflation.
Services inflation, which is viewed as a good measure of domestic price pressures, dropped to 4.9 per cent in September, significantly below the Bank’s expectations.
However, Bank officials cautioned that some of the decrease in services inflation was driven by “volatile categories”, some of which are expected to unwind.
“Services price inflation was expected to remain broadly unchanged over the next six months,” it declared.
The US Federal Reserve will reveal its latest interest rate decision later this evening. Investors anticipate the Fed to cut rates by 25 basis points despite the uncertainty caused by Trump’s election victory.