The Government cannot take credit for cuts in interest rates

Telegraph

3 days ago

The Bank of England's decision to trim its key interest rate by another quarter point this week was widely expected, but there is still plenty to write about. Unfortunately, little of this is good news.
For a start, why on earth is the Monetary Policy Committee (MPC) still cutting rates when the Bank itself now expects CPI inflation to rise further, peaking at 4 per cent in September? This would be double the MPC's 2 per cent target, which is meant to be met 'at all times'.
That is a reasonable question. Indeed, the MPC only voted in favour by the slimmest of margins, with four of the nine members preferring to leave interest rates on hold.
Fortunately, the MPC's mandate provides some flexibility. The mandate allows the target to be overshot temporarily if there are good reasons to expect inflation to drop back to target soon, and if the costs of correcting the overshoot more quickly – in terms of lost output and jobs – would otherwise be too great.
The recent pick-up in inflation partly reflects global factors which are outside the Bank's control. These include the impacts of higher prices for energy and agricultural commodities, which should drop out of the headline inflation rate next year.
Nonetheless, the gap between inflation in the UK and the rest of Europe has widened noticeably since last October's Budget. Despite the same global pressures, inflation in the euro area has settled at around 2 per cent.
The obvious culprit is the continued pass through of higher payroll costs following the large increases in employers' National Insurance contributions and in minimum wages.
It was always likely that these policy choices would backfire on 'working people', both by raising prices and hitting jobs. But they have made the MPC's task much more difficult too.
Despite this, there are certainly some good reasons to expect the jump in inflation (excluding food and energy) to be temporary. The labour market is now cooling rapidly, meaning the risk of further wage-led inflation is much lower.
Moreover, unlike in the post-Covid period when inflation was much stickier than most had expected, the money supply is now under control. This is partly due to the MPC's decision to keep monetary policy tight by selling government bonds, reversing the previous policy of 'quantitative easing'.
Though few will pay much notice, the Bank's preferred measure of broad money (known as M4) is growing at an annualised rate of just 3 per cent. That is unlikely to be enough to sustain inflation much above 2 per cent, unless the UK economy is heading for a prolonged slump.
Alas, the risks to economic activity are skewed to the downside. The immediate threat of a devastating global trade war has faded, but US tariffs will still be substantially higher than a year ago. At home, business and consumer confidence are already stuttering again as another punitive Budget looms in the Autumn.
This has two implications. First, it makes perfect sense to return interest rates towards a more neutral level, rather than keep them higher to cap a rise in inflation that is likely to be temporary.
Even at the new level of 4 per cent, interest rates are (just about) restrictive enough to continue bearing down on inflation, especially with the Bank also persisting with 'quantitative tightening'. The financial markets still expect the MPC to be forced to ease further, with rates bottoming out at around 3.5 per cent next year.
Second, though, the Government cannot take any credit for the Bank of England's decision. The MPC has now delivered five interest rate cuts since last July's election. But the European Central Bank (ECB) has cut its key interest rate seven times over the same period – to just 2 per cent, and eight in total since the peak.
The bottom line is that UK interest rates are still higher than they would have been if UK inflation were not such an outlier. They have only been cut at all because the tiniest majority of MPC members agreed that recession fears should trump the reality of rising inflation. This is not much to cheer.