The Bank of England’s Monetary Policy Committee (MPC) finds itself in a bind. At its most recent meeting, the nine members split narrowly, voting five to four in favour of a rate cut. Such indecision reflects the contradictory signals in the economic data. Growth of 0.3% in the latest quarter, stubbornly high inflation, and upbeat purchasing managers’ indices would usually preclude monetary loosening. Yet beneath the surface, the case for cuts is stronger than the headlines suggest.

Central banks assess economies by measuring two elusive variables: the output gap and the neutral rate of interest, or r*. The former captures whether GDP is running above or below trend. A positive gap, as after the post-pandemic surge, risks overheating; a negative one justifies stimulus. The latter, r*, is the “Goldilocks” rate—not too high to choke growth, not too low to stoke inflation. With the Bank’s base rate sitting at 4%, most economists reckon it lies above neutral. Cuts, therefore, seem overdue.

Matt Brittain of ARIA Private Clients notes that growth of 1.2% on an annualised basis is “maybe a bit above trend, albeit the trend rate of growth is low.” Much of the recent expansion, however, has come from government spending. The private sector is faltering. “There are a lot of reasons to believe a slowdown is coming,” he says.

Unemployment provides another window into slack. Officially, Britain’s jobless rate is 4.7%, a historically low level that implies a minimal output gap. Yet the data are muddied by a shrinking participation rate. Many have retired early or are languishing on illness benefits, neither working nor counted as unemployed. Brittain believes the rise in joblessness hints at “slack increasing,” even if the headline rate suggests otherwise.

Inflation’s new clothes
The Bank’s 2% target remains distant. Inflation, once as high as 11%, has eased but recently ticked back up to 3.8%. This bout, though, is less about demand running ahead of supply, and more about policy and cost pressures. Increases in the minimum wage, energy caps and national insurance have all fed through. These are one-off shocks, not signs of a wage-price spiral.

That matters for policymakers. Demand-driven inflation is sensitive to interest rates; cost-push inflation is not. Raising rates will not make energy cheaper. Still, Simon Lau, another ARIA portfolio manager, warns of “second order effects.” If households and firms expect inflation to persist, they may change their behaviour—seeking larger pay rises or raising prices—embedding higher inflation expectations into the system.

The risk of stagflation—stubborn inflation combined with weak growth—remains low, argues Jackson, another of ARIA’s economists. He contends it requires double-digit inflation, not today’s figures. Moreover, wage growth is already slowing, and any weakening in the labour market should help disinflation along. A hidden variable looms: the vast number of “non-participants” in the workforce. Should they return, wage pressure could ease further.

“Demand-driven inflation is sensitive to interest rates; cost-push inflation is not. Raising rates will not make energy cheaper.”

 

What comes next
Markets are pencilling in around 40 basis points of cuts by mid-2025. The consensus is that today’s 4% base rate sits 50-100bp above neutral. If true, monetary policy is unnecessarily restrictive. Most forecasters therefore expect cuts of 150-200bp over the next 18 months, taking rates down to around 3-3.5%, consistent with long-term estimates of r*.

Brittain thinks the first meaningful move could come in November, as policymakers seek to offset weakening demand with looser policy. Yet supply-side pressures complicate the picture: they are raising costs while simultaneously dampening activity.

Meanwhile, gilt markets are already under pressure. Yields have risen, pushing down prices, as investors bet that rate cuts will arrive more slowly than the economy might like.

For now, the UK is stuck between two worlds: headline data too strong for urgent easing, but underlying dynamics too weak for comfort. The MPC’s split vote reflects this uncertainty. So too does the market’s ambivalence. Rates are heading down—but how quickly, and how far, remains the £64 billion question.

The most recent news flow and political upheavals this week has put some more pressure on UK Gilts, causing prices to soften further. If you would like to discuss the relative attractiveness of UK bonds at this juncture, or investments more generally do not hesitate to reach out to us via your local office.