Rachel Reeves has reason to be cheerful. After last month’s budget, the Bank of England cutting interest rates will come as an early Christmas tonic for the chancellor by lifting some of the pressure on hard-pressed borrowers.
The City had been heavily betting on a sixth cut since August last year, and Threadneedle Street delivered with a reduction in the base rate from 4% to 3.75%. The question, however, is how much further the Bank can go to bring to an end its current easing cycle, after a painful hump in inflation over the past year.
For borrowers, Thursday’s decision suggests the endpoint is coming into focus – spelled out succinctly by the Bank’s governor, Andrew Bailey. “We still think rates are on a gradual downward path,” he said. “But with every cut we make, how much further we go becomes a closer call.”
Some of this reflects deep divisions in the Bank’s monetary policy committee (MPC) over the UK’s inflation prospects. Even though five members on the nine-strong panel, including Bailey, backed a Christmas cut, the four in the minority already reckon the endpoint may have arrived.
Heading into Thursday, a majority call from the MPC had been all but guaranteed after figures showing a pronounced slowdown in headline inflation to 3.2% in November were released on Wednesday. At the same time, the economy is struggling for growth momentum and unemployment is rising, removing some of the kindling required for inflation to reignite next year.
Given these bleak winter conditions, the Bank believes economic growth probably flatlined in the fourth quarter.
For some members of the MPC, the weakness in the economy and widening slack in the jobs market are enough to justify further rate cuts. Last month’s autumn budget could help further justify the case.
Threadneedle Street reckons the chancellor’s measures in last month’s budget – including relief on energy bills, rail fares and prescription charges – will cut headline inflation by 0.5 percentage points from the second quarter of next year. This should be enough to get the rate close to the Bank’s 2% target a year earlier than previously anticipated.
In the views of some on the MPC, this could help to ensure inflation sticks close to the government-set target thereafter, by convincing businesses and households to bargain for wages and set prices in the knowledge that the headline rate is close to 2%.
For others on the MPC, however, there are still worrying signs of problems bubbling underneath the surface that could risk inflation drifting higher.
Central to this is a concern that wage growth remains much higher than would normally be considered usual given the weakness in the economy and rising levels of unemployment.
The Bank’s network of agents estimate that annual pay settlements next year will probably be in the region of 3.5% – significantly higher than levels that are consistent with keeping inflation near to the 2% target.
And while Reeves’s budget measures are expected to subtract from headline inflation in 2026, the MPC thinks the government will probably add to price growth in 2027 and 2028 by between 0.1 and 0.2 percentage points. This would chime with business leaders’ warnings that adding to employment costs – with a higher living wage, employment rights, and planned taxes on pensions – could force companies to increase prices in response.
For Reeves, the Bank’s six rate cuts have provided Labour with ammunition to defend its record. In the short term, that story remains intact.
The hope in Downing Street will be that whacking inflation down in 2026 could help prevent the headline rate sticking at elevated levels. Most economists anticipate at least another cut in interest rates next year as a result. Weaker growth, rising unemployment, and evidence of a further inflation slowdowncould put more on the table. But the endpoint is getting closer.
