QNB expects the Bank of England to take a new path for its monetary policy, and start an easing cycle and cut interest rates, at its next meeting, scheduled for August 2024. This step will be supported by the decline in headline inflation below the target level, the economic recession, and the tight financial conditions.
The bank indicated in its weekly report that the easing cycle will be gradual, unless major unexpected economic developments occur, with two additional cuts of 25 basis points this year.
According to the report, the United Kingdom experienced one of the worst waves of inflation among advanced economies in the period following the Covid pandemic. In response, the Bank of England began an aggressive cycle of tightening interest rates at the end of 2021, under which the main interest rate was increased 14 times. This series of decisions led to raising the interest rate from 0.10 to 5.25 percent, its highest level in 16 years, and it has been maintained since August 2023.
The Bank of England also began a phase of quantitative tightening in early 2022, implying a reduction in its holdings of UK government and corporate bonds. This measure will gradually reverse the expansion of the balance sheet implemented to support financial markets and economic activity during the pandemic.
QNB added that now, with inflation having exceeded the target level for three years and reaching double-digit rates in the second half of 2022, the Bank of England is well positioned to start a new path in its monetary policy, expecting the Bank of England’s monetary policy meeting in August to mark the beginning of a gradual cycle of monetary easing, supported by three main factors: First, after three years of above-target inflation, the Bank of England has managed to control prices, which provides a strong argument in favor of a shift in interest rate policy. The headline inflation rate reached the 2% target in May, which meets an expected prerequisite for a change in the direction of monetary policy.
As overall price measures can show some short-term volatility, central banks closely monitor additional measures that reveal underlying and more persistent trends. In this regard, the key measure is core inflation. By excluding the more volatile components, such as energy and food products, core inflation provides a more stable and informative view of underlying price trends. The latest published data shows monthly core inflation rates hovering around 0.3 percent, down significantly from the peak of 0.9 percent at the start of last year. Moreover, this deflationary trend is expected to continue, which could imply that the Bank of England risks being left behind if it waits too long to cut interest rates, as excessive monetary tightening could negatively impact economic growth and lead to an undesirably low inflation environment.
Second, economic growth is expected to remain weak, although the Kingdom is on track to recover from the mild recession that occurred in 2023. In the second half of the year, economic activity declined for two consecutive quarters by 0.4 percent, due to monetary policy tightening. There are early signs of a modest recovery, with GDP expanding by 0.6 percent in the first quarter of 2024. There is limited scope for a stronger recovery without significant support from economic policies.
The Bank of England sees business surveys as consistent with a slower pace of underlying growth of 0.25% each quarter, while labor market indicators confirm the economy is softening. The unemployment rate has risen by 0.6 percentage points since the last quarter of 2023, and the ratio of job vacancies to the number of unemployed has fallen to pre-pandemic levels, adding to evidence that labor markets are tightening. Bloomberg expects the U.K. economy to expand by a meager 0.7% this year, well below the long-term average of 1.5% and considered very weak after a recession. The weak economic recovery coupled with a loose labor market suggests there is plenty of scope for monetary policy easing.
Third, financial conditions have reached very tight levels on the back of strong monetary tightening. The Kingdom’s Financial Conditions Index provides a useful summary of financial market conditions. This index combines information on short- and long-term interest rates and credit spreads. It rose in the second half of 2023 and is currently at levels not seen since the global financial crisis, when significant turmoil and instability in financial markets led to a credit freeze and a banking crisis.
The report concluded that high interest rates and the quantitative tightening program will continue to keep credit costs high and drain liquidity from the financial system for the foreseeable future, even after the start of the monetary policy easing cycle, noting that credit volumes have been steadily shrinking in real terms for more than a year. The longer it takes for the Bank of England to ease monetary policy, the greater the chances of financial turmoil. In other words, monetary easing has become necessary to reduce the country’s financial weakness.
