Bank Of England Heads For Historically Slow Rate Cutting Cycle

(Bloomberg) -- When central banks start cutting interest rates, they usually move quickly. The Bank of England may choose a more cautious path when its nine-member Monetary Policy Committee decides the time has come to reduce borrowing costs.

What makes this cycle different is that it will take place not in a downturn, but into an economic recovery. Official figures on Friday showed the UK rebounding from a mild recession with the strongest quarterly growth since the end of the pandemic. 

That’s a sharp contrast with the last three cutting cycles — in 1998, 2001 and 2008 — when the central bank was acting to support growth. Each of those times it moved fast and cut steeply.

This week, BOE Governor Andrew Bailey acknowledged the MPC is headed into almost unknown territory. “Most of the cutting cycles ... have actually been prompted by some sort of shock or other, rather than being what I might call a natural cyclical ‘we’ve reached the top and now we go down the restrictiveness curve’,” Bailey told Bloomberg TV after a decision on Thursday to keep the key rate at a 16-year high of 5.25%.

Asked whether there was much precedent for what the bank is about to embark upon, he answered: “I would just caution, there isn’t a lot.” What is about to happen, he added, “is sort of quite interesting – and is something we looked at.” 

Investors are betting on the first rate reductions since the pandemic starting with a quarter point in August, followed by additional one around November. Bailey himself put June in play by saying a cut at the next meeting “is neither ruled out nor a fait accompli.” 

Once the BOE takes the plunge, UK economists expect a rapid series of cuts. The the median forecast of a Bloomberg survey of 44 individuals is for four quarter point cuts over the five meetings from June to December. Bailey was more circumspect. “We have no preconceptions about how fast and how far we might cut,” he said.

Sharp cuts would be helpful to Prime Minister Rishi Sunak, who is hoping for a “feel-good factor” in the economy ahead of elections widely expected in the autumn. At the moment, his Conservative Party lags the Labour opposition in polls and has taken heat for last year’s slump.

At the BOE, policy makers will not be trying to stimulate growth but to pare back the “restrictive” borrowing costs imposed to contain inflation. The plan is to bring rates carefully down to their neutral level. No one knows quite where that is, though, so officials will have to feel their way. It is “something one learns over time,” Ben Broadbent, the outgoing deputy governor, said on Thursday. 

The risk is not of a sudden economic collapse but that inflationary pressures restart. Even before Friday’s unexpectedly strong first quarter official gross domestic product data, the BOE had upgraded its outlook for UK growth. Strong real wage rises will boost consumer spending this year and housing market sentiment is improving, the bank said. 

Instead of looking at past cutting cycles for clues about how policy will develop, a better comparison might be periods where the BOE hiked to return rates to normal levels after a recession, according to Dan Hanson, chief UK economist at Bloomberg Economics.

“It could look more like what’s happened during recoveries from previous downturns where rates have tended to increase far more slowly than they were cut,” he said. His central case remains a rapid series of cuts to 4% starting in June.

All of this suggests the BOE may move slowly, lowering at one meeting and then pausing the next to see how the data evolves. Allan Monks, UK economist at JP Morgan, is predicting such a stop-start trajectory. 

He thinks a cautious approach is needed to calibrate the glide path to neutral in a way that bears down on prices without destroying growth. That, he says, would have the added benefit of keeping UK rates from drifting too far from those in the US, where the Federal Reserve is signaling a “higher for longer” policy.

The Fed is dealing with more entrenched inflation than the UK because America’s economy is overheating, Bailey has argued. If the Fed ends keeping rates elevated while the BOE cuts, Monks fears sterling will depreciate and inflation in the UK shoot up.

“Inflation moderation brings a slow easing, and a recession would be needed to prompt faster cuts,” Monks said. “The Fed matters, not just due to the foreign exchange impact but also because of potentially relevant information about the underlying process.”

He believes there are lessons yet to be learned about how economies have become more resilient to high rates and how tight labor markets pose a greater inflation risk than before.

Paula Bejarano Carbo, an associate economist at the National Institute of Economic and Social Research, also expects slow and gradual rate cuts in case underlying inflation turns out to be more sticky than thought or if geopolitical risks in the Middle East send prices soaring again. “It would be preferable to pause than to reverse rate cuts,” she said.

For now, UK economists still expect the BOE to move quickly to get monetary policy out of restrictive territory and down towards the top end of a neutral level, which is widely thought to be between 3.25% and 4.25%. Either way, the BOE will have to strike a delicate balance.

More stories like this are available on bloomberg.com

©2024 Bloomberg L.P.