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The European Central Bank’s decision last week to cut interest rates has raised speculation the UK will do the same in the coming months.
The Bank of England has remained steadfast in its plan battle inflation and has kept interest rates high, however, the neighbouring Eurozone saw cuts already and on 6 June the ECB cut the key interest rates by 25 basis points in a move that surprised - and dismayed - some.
“Since the Governing Council meeting in September 2023, inflation has fallen by more than 2.5 percentage points and the inflation outlook has improved markedly,” said the ECB’s statement on the cuts. “Underlying inflation has also eased, reinforcing the signs that price pressures have weakened, and inflation expectations have declined at all horizons.”
Other developed countries are also starting to mull their cuts too – on the same day the ECB made cuts the Bank of Canada reduced its target for the overnight rate to 4.75%, with the Bank Rate at 5% and the deposit rate at 4.75%. The Bank is continuing its policy of balance sheet normalisation.
The ECB said its cuts were necessary as the latest Eurosystem staff macroeconomic projections said economic growth was at 0.9% in 2024, 1.4% in 2025 and 1.6% in 2026, while inflation is projected to average 2.5% in 2024, 2.2% in 2025 and 1.9% in 2026.
On top of this, relative to the average annual inflation rates in 2022 and 2023 of 8.4% and 5.4% respectively, considerable disinflation has already occurred, with the latest inflation figure at 2.6% in May, said Philip Lane, Member of the Executive Board of the ECB, at the Banking & Payments Federation Ireland (BPFI) National Banking Conference this week in Dublin.
“These increases are driven by service dynamics, combined with a less clear deflation in energy and goods, despite the recent drop in oil prices."
In its statement, the ECB said it had followed a 'data dependent' approach, which “means it will continue to take decisions in line with macroeconomic data,” according to analysis from Spanish insurer MAPFRE’s asset management arm, which was cautious and emphasised that the cuts might be too early. “This is the first rate cut in eight years after an aggressive hike from 2022 to tackle inflation, which is still some way off the 2% target rate.”
“These increases are driven by service dynamics, combined with a less clear deflation in energy and goods, despite the recent drop in oil prices,” said Eduardo Garcia, senior economist at MAPFRE Economics, who added to proceed with caution.
While the strategy has been questioned most welcomed the cut as a way to kickstart Europe’s sluggish economies.
The UK’s central bank has been even more cautious about inflation than its continental cousin, saying in February that “inflation is still above our 2% target. High inflation affects everyone, but it particularly hurts those who can least afford it. We need to make sure it comes down further.”
At that time others warned about rising unemployment in the UK due to the effects – partly – of the higher interest rates, which appears to now be coming to fruition and could see things begin to change.
According to the UK’s Office of National Statistics (ONS), the Consumer Prices Index including owner occupiers’ housing costs (CPIH) rose by 3% in the 12 months to April 2024, down from 3.8% in the 12 months to March in the latest numbers, which were released on May 22.
On a monthly basis, CPIH rose by 0.5% in April 2024, compared with a rise of 1.2% in April 2023. The ONS said that “Falling gas and electricity prices resulted in the largest downward contributions to the monthly change in both CPIH and CPI annual rates, while the largest, partially offsetting, upward contribution came from motor fuels, with prices rising this year but falling a year ago.
The more general Consumer Prices Index (CPI) rose by 2.3% in the 12 months to April 2024, down from 3.2% in the 12 months to March.
“Falling employment, rising unemployment and rising economic inactivity do not paint a pretty picture of the UK labour market."
Other numbers came out this week that showed the UK’s unemployment rate was increasing; 4.4%, versus 4.3% in the three months to March and market expectations of 4.3%, according to information from Trading Economics.
Economic Inactivity rose quarter-on-quarter to 22.3% and annual wage growth came in at 5.9%, versus 5.7% in the three months to March and market expectations of 5.7%, said Trading Economics.
With rising unemployment, the pressure will come on the Bank of England to begin easing up on the medicine to curtail the UK’s “sticky inflation”.
With a combined rise in unemployment and fall in inflation pressure could be on the Bank of England to lower rates.
“Falling employment, rising unemployment and rising economic inactivity do not paint a pretty picture of the UK labour market,” said Nicholas Hyett, Investment Manager at Wealth Club. “Falling vacancies makes those numbers particularly concerning, suggesting there is a genuine lack of demand for staff.”
Hyett added there were some redeeming features for the UK economy - real wage growth remains over 2% year-on-year – “but this is, nonetheless, precisely the kind of sign the Bank of England has suggested it's been waiting for to start cutting interest rates,” he added.
Counterintuitively that would come as a relief to [homeowners], potentially a rare bit of good news for the government in a so far lacklustre election campaign. In reality though it probably comes too late to influence house prices ahead of polling day."
Lane said in his speech that “after nine months of holding the deposit facility rate at 4.0%, we cut it to 3.75 Over the interval since our September 2023 monetary policy meeting, the projected timely return of inflation to our target has been reconfirmed in the December, March and June projection rounds,” he said.
Lane noted that, for instance, over the last four forecast rounds, the projected fourth quarter-on-fourth quarter HICP inflation rate for 2025 has oscillated within the “very narrow interval of 1.9% to 2.0%”.
“As 2025 draws closer, the timeliness of the projected return to target looms larger on the horizon,” he said. “In addition, in terms of the sustainability of maintaining inflation at the target, the inflation outlook for 2026 has been reconfirmed over the last three projection rounds.”
He added that the speed of disinflation has been faster than expected, which has led to a reduced risk to stability by inflation.
"Inflation in the UK has fallen to its lowest level since September 2021, from a peak of 11% in 2022 to 3.2% in March.”
Others have said it was too early and that the ECB made the wrong decision. Alberto Matellán, the Chief Economist at MAPFRE Inversión, still feels that the macro situation in Europe does not support the cuts: “from the macro data, it’s not justified”.
The Bank of England said in its latest Monetary Policy Report, released in May, that “inflation in the UK has fallen to its lowest level since September 2021, from a peak of 11% in 2022 to 3.2% in March.”
“The progress we are seeing in the key economic data is encouraging, but we are not yet at the point of cutting interest rates,” said the report. “We need to see more evidence that inflation will stay low before we can do that.”
It added that “we need to make sure that inflation comes down to 2% and stays there. Progress is encouraging, but we are not yet at the point of cutting interest rates.”
The next report will not be until early August, by which time there will be a new parliament sitting and possibly a new prime minister in Downing Street who would have a different plan for the UK economy.
Keir Starmer’s Labour party has promised to put economic growth above almost all other plans, which could have some inflationary effects.
All these changes will also partly hinge on what the US Federal Reserve does. “It is not all about the Fed – but it is all about the Fed if you know what I mean,” said Colin Tipping, Chief Investment Officer, Compre Group, to Insurance Investor in May. “You must consider the Fed, the European Central Bank (ECB), and the Bank of England (BoE) simultaneously as an international player. We have Lloyd's business; we have Solvency II business; and we are in North America, so we are not just thinking about what the BoE is doing.”
Time will tell about who jumps second.
