Was the Bank of England right to start lowering interest rates?
Summary
- Andrew Bailey takes a calculated risk
It was a close call. On August 1st the Bank of England announced that it was cutting interest rates by 0.25 percentage points. The votes of its Monetary Policy Committee (MPC) were split five to four. Ahead of the announcement, markets had also been divided, pricing in roughly a 60% chance of a cut. The bank says it intends to reduce rates only gradually from here. Markets reckon it will do so once more before the end of the year (see chart).
The lack of consensus, and the caution, are understandable. Some uncertainty is inevitable in central banking. Economic data tend to be muddled and contradictory, especially over the short term. The most reliable data series, like GDP releases, take months to compile and are stale before they even arrive. Statistical offices frequently revise releases after the fact. But Britain’s economic situation has recently become especially difficult to parse.
The headline rate of inflation, which the bank formally aims to control, has now hit its 2% target on the nose. But its decline mostly reflects big drops in volatile energy and food prices. The core inflation rate, which strips those prices out and tends to better reflect the underlying pressures on the economy, is still running at 3.5%. Other measures, like services inflation and nominal wage growth, are even higher: at 5.7% and 5.2%, respectively. Inflation is down but not out.
What of growth and the labour market? There, again, the picture is murky. There is certainly a case for optimism. GDP rose by 1.5% in the 12 months to May, much faster than most forecasters—including the bank itself—expected. But that could be a temporary sugar-rush as Britain exits recession. The bank thinks so, writing that “underlying momentum appears weaker" in a report accompanying the rate decision. Corroborating that view, the labour market seems to be creaking: the unemployment rate has risen and job vacancies are down. That could presage a slowdown. Although a slight cooling would be a welcome help in controlling inflation, a sharper deterioration would be unpleasant.
The poor quality of much of Britain’s economic data does not help. The two data series that should matter most for interest-rate decisions are unemployment and inflation. Both have been faulty recently. The Labour Force Survey, which is used to generate the unemployment rate, has been less reliable ever since survey-response rates fell during the covid-19 pandemic. The Office for National Statistics is in the middle of refurbishing the survey but the figures are unusually jumpy and tough to interpret in the meantime.
The latest round of inflation data, covering June, was also distorted by an unusually high reading for hotel prices. Data sleuths tracked that down to a handful of individual price readings. They initially pointed to higher prices around Taylor Swift’s Eras Tour as a culprit. Pantheon Macroeconomics, a consultancy, cross-referenced the concert dates and suggests that a concert in Cardiff by P!nk, an American singer-songwriter, could have been to blame.
So, was cutting in August the right decision? Any central banker waiting for perfect information has left it too late. Looming over the MPC’s decision is the criticism it received for being too slow to raise rates in response to rising inflation in 2021 and 2022. Several of the bank’s peers have now reduced rates. The European Central Bank has already done so. The Federal Reserve demurred at its July 31st meeting but signalled that a move is likely at its next meeting in September.
Although out-of-control inflation is the biggest single threat to a central bank’s credibility, keeping policy tight and choking growth during a slowdown would also be a bad look. In other words, moving now makes sense. A bank rate of 5% remains restrictive and the MPC has ample space to speed or slow the easing from here. It just needs the view of the road ahead to be clearer.
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