Bank of England is about to start a monetary easing cycle

The UK has experienced one of the most severe post-COVID-19 inflation spikes of any advanced economy. The Bank of England responded strongly, launching a rate tightening cycle in late 2021, during which it raised its base rate 14 times. This series of decisions took the rate from 0.10% to 5.25%, the highest level in 16 years, where it has remained since August 2023.

In addition to the sharp tightening of interest rates, the Bank of England also began a phase of “quantitative tightening” in early 2022, including reducing the stock of government bonds and UK corporate bonds. The effect of this approach is to gradually slow the balance sheet expansion implemented during the COVID-19 pandemic to support financial markets and economic activity.

Now, after three years of above-target inflation, perhaps even reaching a double-digit peak in the second half of 2022, the Bank of England finds itself in a favorable environment for a new direction in the trajectory of monetary policy. We believe that the Bank of England’s August monetary policy meeting will mark the beginning of a gradual monetary easing cycle. In this article, we examine three main factors that support our forecast.

UK consumer price inflation
(%, year-on-year, 2019-2024) Source: Haver Analytics, QNB Economics

First, after three years of above-target inflation, the Bank of England has successfully controlled prices, providing a strong case for adjusting interest rates. In May, headline inflation reached the monetary policy target of 2%, which was a condition for the highly anticipated shift in the monetary policy stance.

As aggregate price measures can be subject to some short-term volatility, the central bank keeps a close eye on other indicators that reveal underlying, more persistent trends. In this regard, core inflation is a key indicator. By excluding the most volatile components such as energy and food, core inflation can provide a more stable and informative view of underlying price trends. The latest data showed that monthly core inflation was close to 0.3%, a sharp drop from the peak of 0.9% at the beginning of last year. Moreover, this deflationary trend is expected to continue, which could mean that the Bank of England may find itself “on the back foot” if it delays cutting interest rates, as overly restrictive monetary conditions could harm economic growth and produce an inflationary environment that would be too low.

Moreover, even if the UK embarks on a recovery path after a small recession in 2023, economic growth is expected to remain subdued. In the second half of 2023, economic activity fell by 0.4% for two consecutive quarters, partly due to the impact of tight monetary policy. Signs of recovery are already evident, with GDP growing by 0.6% in the first quarter of 2024. However, in the absence of significant political support, a more pronounced recovery seems difficult to imagine.

Notably, the Bank of England insisted that business surveys showed that the underlying pace of growth was slowing by only 0.25% per quarter. Labour market indicators also confirm observations of economic weakness: the unemployment rate has risen by 0.6% since the fourth quarter of 2023. Moreover, the vacancy/unemployment ratio, a measure of tight labour market conditions, has fallen back to its pre-pandemic level, providing further evidence of easing labour market conditions. More generally, the UK economy is expected to post a fragile 0.7% growth this year, according to the consensus forecast for GDP growth in a Bloomberg survey. This figure is significantly below the long-term average of 1.5% and is particularly low after a recession. The weak economic recovery and sluggish labour market bode ill for the prospect of loose economic policy.

UK Financial Conditions Index
(Index 100 = average since 2005) Source: Goldman Sachs, QNB Economics

Finally, following a significant monetary tightening cycle, financial conditions have reached very tight levels. The UK Financial Conditions Index aptly summarizes financial market conditions.

The indicator contains information on short-term and long-term interest rates and credit spreads. The index peaked in the second half of 2023 and is currently reaching its highest level since the global financial crisis, when financial markets were severely turbulent and unstable, leading to credit freezes and banking crises. Even after the easing cycle begins, high policy rates and quantitative tightening will continue to keep credit costs high and drain liquidity from the financial system in the short term. In fact, the amount of credit has continued to shrink in real terms for more than a year. The longer the Bank of England relaxes its policy, the greater the risk of financial instability. In other words, monetary easing is also essential to reduce the country’s financial vulnerabilities.

In summary, we think the BoE will start a rate-cutting phase at its next meeting, and below-target headline inflation, stagnant economy and restrictive financial conditions should support such a move. We think the easing cycle will be gradual, with two more 25bp rate cuts this year, barring major and unexpected developments in the economy.