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Traders are betting that the Bank of England (BoE) will cut interest rates in September despite a rise in UK inflation as the US Federal Reserve has also signalled it is ready to lower borrowing costs.
Andrew Bailey raised hopes of more rapid interest rate cuts for millions of mortgage holders as he said inflation appears to be fading more quickly than feared.
The governor of the Bank of England said the “persistent” factors keeping price rises high “appear to be smaller than we expected”, raising the possibility that Threadneedle Street will again cut interest rates before the end of the year.
“We are seeing a lower level of inflation persistence than we expected a year ago. But, we need to be cautious because the job is not completed – we are not yet back to target on a sustained basis,” he said at Kansas City Fed’s annual economic symposium in Jackson Hole.
Money markets now indicate that there’s a 45% chance that the Bank will cut rates to 4.75% next month, from its current level of 5%. Before the inflation data came out, a September rate cut was only a 36% probability, according to City pricing.
Markets still think there is still room for a second cut later in the year, which would bring the base rate down to 4.5%.
Swap traders are also currently betting that the Federal Reserve and European Central Bank will settle at rates of just above 3% and 2% respectively over the next two years, compared to about 3.5% for the BoE.
Matt Amis, an investment director at Edinburgh-based abrdn, has ramped up bets that the BoE will deliver deeper interest-rate cuts than what the market is expecting.
“The BoE is mispriced versus the Fed and the ECB,” he told Bloomberg, adding that the trajectory for the three economies won’t be too dissimilar and that the Bank terminal rate will be closer to peers.
There is also mounting expectations that the Fed will cut interest rates from as early as September.
Powell sent a clear message to markets in a key speech, saying “the time has come” for the central bank to begin lowering interest rates.
Speaking in Jackson Hole, he said: “The time has come for policy to adjust.”
“The direction of travel is clear,” Powell added, “and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks.”
Investors now see about a 76% chance of a 0.25 percentage point cut in interest rates when the Fed meets on 18 September.
The UK consumer prices index (CPI) rose for the first time this year to 2.2% in July, up from 2% in both May and June, according to the Office for National Statistics (ONS). This was less than the 2.3% rise expected by analysts.
Services CPI inflation dropped for a sixth consecutive month from 5.7% to 5.2%, having been forecast by analysts to fall to 5.5%.
Capital Economics analysts say inflation rose by less than expected, and that the data behind headline inflation is encouraging.
“The sharp fall in services inflation from 5.7% to a two-year low of 5.2% will reassure the Bank of England that the disinflation process is on track and opens the door to more interest rate cuts later this year,” Ruth Gregory, deputy chief UK economist at Capital Economics, said.
Capital believes interest rates will fall throughout next year to 3%. Markets currently think 3.5% is a more likely destination in 2025.
“The main surprise was that the fall in restaurants and hotels inflation from 6.2% to 4.9% was bigger than the drop to 5.6% we had forecast.
“And importantly for the Bank of England, the decline in services inflation from 5.7% to 5.2% was much bigger than anyone anticipated,” Gregory added.
Read more: Where to invest your money when interest rates are falling
Pierre Roke, associate at Validus Risk Management, also believes two more interest rate cuts are possible this year.
“Markets had a keen interest in services inflation — after two consecutive months of hotter-than-expected readings at 5.7%, the hawkish Bank of England committee members, who voted to hold, highlighted this as a critical factor, making it a key market signal.
“Today’s 5.2% print vs 5.5% expected print validates the more dovish committee members and potentially leaving room for not just one more cut this year but two,” he said.
However, a Reuters poll of economists published on Wednesday suggested the Bank of England will cut interest rates just once more this year, in November.
A majority 65% of economists, 39 of 60, forecast the BoE to only cut rates once more this year, leaving borrowing costs at 4.75%. Twenty saw two or more reductions and one said none.
Median forecasts showed bank rate at 4.5% at end-March, 4.25% at end-June and a final 2025 cut to 3.75% in the third quarter.
The Bank of England tends to cut interest rates as inflation comes down towards its 2% target. It cut rates from 5.25% to 5% earlier this month after holding them at this level for a year.
Governor Andrew Bailey struck a cautious tone after announcing the first cut in interest rates.
“We need to make sure inflation stays low and be careful not to cut interest rates too quickly or by too much,” Bailey said.
According to a Bank of England forecast released earlier this month, inflation will rise to 2.75% by the end of 2024 and stay high for the foreseeable future.
Bolstering the chances for two rate cuts before the end of the year is also GDP data that showed the UK economy growing by 0.6% in the second quarter.
Neil Birrell, CIO at Premier Miton Investors, said: “The second quarter seems like a long time ago, but the GDP data confirms that the UK economy is in good health.
“The Bank of England is in the nice position, unlike other central banks, of having a level of surety in the data it is seeing, when setting policy. With inflation playing ball as well, the path to lower interest rates looks to be set, the timing of the cuts is now the focus.”
Read more: UK economy continues recovery with 0.6% growth
ICAEW economics director Suren Thiru added: “The UK’s strong second quarter owes more to temporary momentum from the large recent falls in inflation and a boost to consumer spending from events like Euro 2024 than from a meaningful improvement in the UK’s underlying growth trajectory.
“These strong second quarter growth figures may delay the next UK interest rate cut by giving those rate setters still worried about domestic price pressures enough assurances over the strength of the economy to hold off relaxing policy.”
The Bank of England has made clear that it wants to see services inflation fall before it will feel confident cutting interest rates further.
Yael Selfin, chief economist at KPMG UK, said: “Despite a modest rise, inflation was relatively subdued in July as weaker core and food price inflation largely offset the diminishing impact of earlier falls in energy prices.
“This should provide a degree of comfort for MPC members as the Bank’s own forecasts earlier this month pointed to a sharper uptick.”
Deutsche Bank also believes that it possible the UK will see multiple interest rate cuts before the end of the year.
“We will get another CPI report ahead of the September decision. The next round of inflation and labour market data will be crucial in deciding whether the MPC could push through a September rate cut.
The latest jobs data also showed a cooling down in wage increases, which should appease Threadneedle Street.
Average earnings excluding bonuses slowed to 5.4% from 5.8% in the three months to June and was 2.4% higher after taking inflation into account, said the ONS. It is the lowest rate in almost two years in the three months to June.
However, some analysts are not so bullish on the Bank cutting rates, as inflation is now back off target.
Monica George Michail, associate economist at the NIESR, said: “Underlying inflationary dynamics continued to slow with core inflation at 3.3% and services inflation at 5.2%. Despite the lower figures, these remain elevated and may lead the Bank of England to exercise some caution with regards to further interest rate cuts.”
Read more: UK government borrowing highest since pandemic
Catherine Mann, a hawkish member of the Bank’s monetary policy committee, which sets interest rates, has warned that the UK should not be “seduced” into thinking inflation will stay low over the coming year.
Aaron Hussein, global market strategist at JP Morgan Asset Management, also suggested the Bank is unlikely to cut in September:
“[The] inflation print will reassure members of the committee that voted for a rate cut last month that they may finally be taming the inflation beast.
“However, with economic growth on a cyclical upswing since the start of the and the labour market remaining resilient, there remains a risk that cutting too quickly will fan the inflation flames. We therefore think it’s unlikely that the Bank will follow up its August cut with a cut in September.
“Investors banking on imminent rate cuts will therefore be disappointed.”
When the BoE meets on 19 September, it will have a new rate-setter. Alan Taylor, an economics professor with a focus on international economics and financial crises, has been appointed to the MPC – succeeding Jonathan Haskel, one of the committee’s most hawkish members.
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