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If the European Central Bank thinks it’s safe to cut interest rates it’s high time for the Bank of England to follow suit. The ECB is overwhelmingly likely to start the first of a series of reductions at its meeting today, cutting its main refinancing rate by 0.25 percentage points to 4.25 per cent.
But here, unless something really dramatic happens in the next few days, the Bank’s Monetary Policy Committee (MPC) is widely expected to hold the Bank rate at 5.25 per cent when it meets in two weeks’ time. If it does so, it will be making a serious mistake.
Here’s why. For a start, UK inflation is now lower than in the Eurozone. The latest Consumer Prices Index there was 2.6 per cent in May, up from 2.4 per cent in April. Here, our April number was 2.3 per cent, and the May figure to be published on 19 June – the day before the MPC decision – is widely expected to be lower still, either 2.1 per cent or even 2 per cent.
Inflationary pressures are weakening
Later this autumn the headline inflation rate may climb a bit, for the underlying forces of inflation, especially wage growth, remain strong. But inflationary pressures more generally are weakening. For example, inflation in the all-important services industries is coming down, and according to the most recent purchasing managers’ indices, is set to fall further.
There is another key factor. Changes in interest rates take a long time to have their full effect on inflation: the general rule is that the lags are a year to 18 months, maybe even longer. So what the central banks do now will be felt in the inflation numbers of the second half of 2025. But they have a much earlier impact on business sentiment, and on key markets, including housing.
The wait for cheaper money
There is some sort of economic recovery happening, but it is fragile. People are holding back on all sorts of purchases, including cars. Companies are replacing their vehicles, and that is holding up overall demand, but private sales are running down 13 per cent on the low levels of a year ago. The housing market has been soft through the first part of this year, though the Nationwide Building Society reported a recovery in May. Everyone seems to be waiting for cheaper money.
Sentiment matters. No-one should wish for an out-of-control boom, but right now there is no danger of that. What is needed by companies and consumers alike is a clearer indication that the path to cheaper money is secure. That is not to call for the ultra-low interest rates that the world’s central banks have imposed for most of the period between 2009 and 2021, the costs of which have become clear. Rather, it is to say that just as the central banks, including the Bank of England, made the mistake of increasing rates too slowly when inflation struck, they should not now make the reverse mistake of cutting them too slowly now that it is coming back under control.
There are economic costs of too-high interest rates in lost jobs, output, and real wealth, just as there are costs of too-low rates in their impact of inflation and misallocation of capital.
Why a delay is expected
So what will the Bank of England do? At the moment the financial markets expect no change at the meeting this month. There is no meeting in July, and everyone expects the first cut in rates to come through in August. One reason for that is that the quarterly Monetary Policy Report is published then, and that has the Bank’s up-to-date forecasts for the economy.
However, there is another reason why a delay is expected. There is a convention that during an election campaign there should not be any significant changes in monetary policy. Here, a cut in rates might be seen to be endorsing the policies of the government of the day.
Neither of these objections really hold water. The economists at the Bank supply the MPC with up-to-date estimates, and the members in any case can see for themselves what is happening. It is their job to look beyond the information provided by the staff and make an independent judgement. As for the politics, maybe in a tight election some change in interest rates, up or down, might have an impact on voter choices, but this one is not tight. Actually, a change in rates would be a signal that the MPC was ignoring the election and putting the economy first.
So will they do it? The most interesting thing that happened at the last MPC meeting was that the deputy governor for markets and banking, Sir Dave Ramsden, switched his vote from no change to a cut. He is much respected, having been in post since 2017 and before that was for 10 years chief economic adviser in the Treasury. He understands markets, and has an intuitive feeling for the UK economy, something that is otherwise rather lacking at the Bank. If he is worried about the delay in cutting rates, so should the rest of us.
The cut by the ECB today, assuming it does indeed happen, would give us cover. The Bank should get on with it.
Need to know
I suppose, standing back from the current preoccupation with central bank policy, what we really want to know is what will happen to longer-term rates. Put it this way. We know, or at least can be pretty sure, that short-term rates will be down to the 3 per cent to 4 per cent region by the end of next year, and what happens after that will depend on whether the longer-term path of inflation is really secure at around the 2 per cent level.
But what I find fascinating is the prospect for bonds. Take 10-year gilts. They are trading around 4.2 per cent, down from the 4.7 per cent peaks they were trading at last summer and autumn, but way up from the 3.5 per cent trough last December.
US treasuries show much the same volatility, now 4.3 per cent, having almost touched 5 per cent last October, but up from below 3.8 per cent in December. These numbers matter because they set the rate at which governments can borrow, but also yields for all commercial borrowers, and for longer-term mortgage holders too.
If you think this one through, taking the UK government as an example, the difference between able to fund itself at 4.7 per cent and 3.5 per cent is enormous. The national debt was £2,720.8bn at the end of last year, equivalent to 101.3 per cent of GDP on the Office for National Statistics’ international calculation. Not all of that has to be rolled over every year, and the average maturity of gilts, at 15 years is very long by international standards, as the Office for Budget Responsibility notes.
But the grind every year of having to refinance part of the debt at over 4 per cent is a huge burden on current taxpayers. And we are not getting the debt down. In fact under both parties’ tax and spending plans the country will struggle to hold it level as a percentage of GDP for the rest of this decade.
It gets worse. The whole country, ordinary home-buyers and giant corporations alike, has to pay a premium over whatever the government has to stump up. Pretty much the same situation applies throughout the world. We are all awash with debt, and there is no easy way out – except hoping that inflation will nibble away at the real value of the debt to bring it down to bearable levels.
More about this in future commentaries here; at this stage let’s just hope that the Bank presses on with some cuts in its interest rates.
This is Armchair Economics with Hamish McRae, a subscriber-only newsletter from i. If you’d like to get this direct to your inbox, every single week, you can sign up here.