Bank of England to maintain interest rates despite inflation reaching 2% target

The Bank of England will leave its key interest rate unchanged at a 16-year high of 5.25 percent at its meeting next Thursday, even though inflation has reached the two percent mark.

According to figures from the Office for National Statistics, the consumer price index (CPI) fell to 2% in May, compared with 2.3% in April.

The figure shows that prices are still rising, but at the slowest pace since July 2021. It follows a sustained period of high inflation in the UK, which peaked at 11.1% in October 2022 – the highest level since 1981.

The Bank of England will look at these figures on Thursday to decide on further interest rate measures.

However, services sector inflation, a key indicator closely watched by the Bank of England, fell slightly short of analysts' expectations, coming in at 5.7 percent year-on-year, compared to the market's expectation of 5.5 percent.

Experts have noted that last month's inflation data, particularly services sector inflation, which exceeded the bank's expectations, may have been a key consideration for the bank. This metric, which examines price increases across the sector, is “currently the predominant part of monetary policy decisions,” according to ING economists.

Thomas Pugh, economist at RSM UK, said: “Services sector inflation, which is a better indicator of underlying price pressures in the economy than headline inflation, again fell short of expectations, slowing to just 5.7 percent compared to expectations of 5.5 percent.”

“This will raise concerns at the MPC that underlying price pressures in the economy are not easing as quickly as expected, making a rate cut in August less likely.”

Nevertheless, the economist does not rule out a rate cut in August. He added: “We expect inflation to fall below 2% in June, setting the stage for an MPC rate cut in August.”

“Inflation is likely to average just above 2% for the rest of the year, giving the bank plenty of room to cut interest rates.

“Our base case still assumes that interest rates will end the year at 4.5%, but the risks have clearly shifted to fewer rate cuts this year.”

Read more: Inflation in the UK falls to the Bank of England’s 2% target

James Smith, head of research at the Resolution Foundation, also warned that services price inflation could be higher than expected. He said: “And while headline inflation is back to normal levels, domestic services price inflation remains high. This inflation will be a concern for the Bank of England and could give cause for reflection when it comes to cutting interest rates.”

Martin Sartorius, chief economist at the Confederation of British Industry, said the decline in inflation “sets the stage” for a rate cut in August.

The story continues

Thursday's decision will almost certainly result in interest rates remaining unchanged, as most economists consider it highly unlikely that the Bank of England would be willing to cut rates in the middle of an election campaign.

Threadneedle is in a wait-and-see position as it abides by pre-election campaign rules, meaning its policymakers are not allowed to make speeches or public statements. This silence makes a rate cut in June unlikely.

Sandra Horsfield, economist at Investec, said this was important because if policymakers “surprise” the market with their decision on Thursday, they would not be able to “correct any misinterpretations” of their interest rate decision until the general election on July 4.

“Why rock the boat when there is no need to rush and no way to stabilize it?” she asked.

The key interest rate is currently 5.25% and will remain at this level since August 2023.

Analysts at AJ Bell said the bank's task may have been complicated by the announcement of a general election on July 4.

They said: “Governor Andrew Bailey and his colleagues on the MPC may not wish to act in a way that could be perceived as favoring one political party over another in the run-up to the July election.”

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When will interest rates fall?

Last month, policymakers hinted at the possibility of a rate cut as early as June, but investors now believe that is unlikely after economic growth, wage increases and services inflation all came in higher than expected.

Money markets believe that August 1 is still the most likely date for the Bank of England's first interest rate cut since 2020.

Investec believes the first rate cut could come in August, but that two committee members, Swati Dhingra and Dave Ramsden, are likely to vote for a cut again on Thursday.

According to a Reuters poll, 63 out of 65 economists expect the first cut to come on August 1. Most also expect a further cut before the end of the year.

The Taylor Swift Effect

Singer Taylor Swift is not usually associated with British interest rates, but the economic impact of her tour could be enough to postpone a possible interest rate cut by the Bank of England in September, investment bank TD Securities said in a statement.

“We still expect the BoE to cut interest rates in August, but inflation data for this month could lead to the Monetary Policy Committee (MPC) remaining inactive in September,” said the bank's macro strategist Lucas Krishan and head of global macro strategy James Rossiter.

However, with hundreds of thousands of Swift enthusiasts flocking to London in August to see Taylor Swift perform, the boost from economists may be enough to make Threadneedle Street reconsider the timing of a rate cut.

For the duration of Taylor Swift's “European Eras” tour, hotel prices in the concert cities are expected to rise by an average of 44 percent, according to a recent report from Lighthouse.

In some cities such as Liverpool, Warsaw and Stockholm, hotel prices were expected to rise by over 100% during this period.

According to Barclays, Taylor Swift fans in the UK are likely to spend around £848 on things like tickets, accommodation, clothing and travel.

“An increase in hotel prices could then be significant, temporarily increasing services inflation by up to 30 basis points (+15 basis points on the total side),” warned Krishan and Rossiter.

If inflation is falling, why aren't interest rates falling?

The main reason for high interest rates is to reduce inflation, but with price increases slowing, why is the Bank of England not cutting interest rates?

Read more: When will interest rates fall and what should you do?

While inflation in the UK fell from a peak of 11.1% in October 2022 to 2% in May, meeting the central bank's target, the Bank will have noted last month's inflation data, with services sector inflation still above expectations.

Susannah Streeter, head of money and markets at Hargreaves Lansdown, said: “But it doesn't look like the Bank of England will join the celebration and cut rates immediately. Policymakers are still keeping an eye on high wage inflation, with salaries including bonuses still at 6% last time out. However, a cut in August is still a very real possibility.”

Read more: UK interest rates expected to remain unchanged ahead of general election

Following rate cuts by the Bank of Canada and the European Central Bank this month, the total number of global rate cuts in 2024 is 70, according to the website CBRates.

The US Federal Reserve left its key interest rate unchanged last week and signaled that only one reduction was to be expected by the end of the year.

“Although the Bank of England is now expected to follow the ECB's lead and intervene before the US Federal Reserve, the extent to which UK interest rates can diverge from those in America may still limit the MPC's room for maneuver,” said AJ Bell.

“Too large a gap between the UK base rate and the Fed's policy rate could pull capital out of the pound and into the dollar, weakening the UK currency. This carries the risk of rising inflation as the UK buys and imports more than it sells and exports,” added analysts at AJ Bell.

The Bank of England will announce its interest rate decision this Thursday at 12 noon.

Attention: Hopes for interest rate cut suffer further setback