Cooling UK labour market puts pressure on Bank to cut interest rate

Concerns about the UK’s slowing labour market are growing, but will the Bank of England budge and begin cutting interest rates faster this year?

The latest jobs figures show another month of slowing wage growth, contracting payrolls and declining vacancies, which extend the run of loosening labour market conditions that markets think will prompt the Bank into another rate cut in August. The jury is out, however, on whether the Bank’s monetary policy committee (MPC) has seen anything worrying enough to quicken the pace of its monetary easing beyond the present one rate cut a quarter.

“The Bank seeks more labour market slack in order to tame pay growth and inflation,” Bruna Skarica, UK economist at Morgan Stanley, said.

• Why inflation rose more than expected in June

She said Huw Pill, the Bank’s chief economist and a more hawkish rate-setter, thinks the unemployment rate will have to rise “in excess of 5 per cent” to assuage concerns about inflation.

Unemployment rose in May to a four-year high of 4.7 per cent and the Bank’s own models do not show it rising above 4.8 per cent. Skarica said that neither the Bank nor the government should be surprised by the recent return of high inflation coupled with a cooling jobs market and higher unemployment.

“The Treasury has imposed a payrolls tax and minimum pay has risen by around 50 per cent in the past five years in the UK,” she said. “Stealth taxes keep inflation high, while regulatory and monetary policy keep labour demand frozen.

“This is all to say that this build-up of slack we are seeing in the UK economy, paired with elevated headline inflation, is not much of a surprise: it is a result of the UK’s policy mix.”

Inflation rose in June to 3.6 per cent, the fastest pace since January 2024 and is now above the Bank’s forecasts.

On one side of the divide on the nine-strong MPC are hawkish members such as Pill, who fear that the resurgence in inflation will lead to “second-round effects”, where workers will demand inflation-busting pay and companies raise prices. The Bank’s surveys have yet to find clear evidence that this entrenched inflation dynamic has taken hold.

On the other side are doves, who worry that the Bank is already behind the curve in supporting the jobs market when companies are saying that they are already cutting back on hiring, reducing headcount and offering fewer hours: factors that should lead to wage disinflation.

Andrew Bailey, the Bank’s governor and usually the median voter on the MPC, has recently expressed more concerns about the state of the slowing jobs market than about another climb up in inflation. He told The Times this week that he expected earnings to fall into the 3 to 4 per cent range in the coming year.

Crucially, the Bank thinks that the rise in employers’ national insurance contributions (NICs) is being managed by companies through reduced hiring and offering fewer hours rather than being passed through to consumer prices. Inflation figures suggested this week, however, that some firms were dealing with NICs by raising prices, particular in food and drink.

Investors and economists will be watching the MPC members’ forthcoming speeches and the committee’s August meeting for signs that the central bank is now prioritising supporting the labour market and looking through the rise in inflation.

The Bank’s dilemma makes the UK increasingly anomalous among advanced economies three years on from a global energy crisis that lifted prices across most rich countries. Inflation in the eurozone is more likely to undershoot 2 per cent in the coming years, leading the European Central Bank into aggressive easing this year.

In the US there are scant signs of an inflationary outburst, despite the consistent threat of tariffs. The Federal Reserve, which has not cut interest rates this year, is now under pressure to support a slowing jobs market and meet its secondary target to achieve full employment.

The path of UK interest rates beyond August remains murky. Modupe Adegbembo, UK economist at Jefferies, thinks the Bank will have to make two more interest rate cuts this year. “We think the evidence of labour market cooling will be sufficient to outweigh the inflation surprise and the fact that wages remain elevated, especially given the broader economic slowdown and weakening business confidence.”

Faster interest rate cuts would help the government, whose fiscal pressures have worsened in a higher-for-longer monetary policy environment.

The jobs figures also had some good news for Labour, showing that the inactivity rate, which has been historically high since the pandemic, dropped to 21 per cent, the lowest since 2020. That suggests that those who have been sitting on the sidelines of the jobs market have been prompted to return by cost of living and other economic pressures. A growing workforce “could be disinflationary”, Rob Wood, at the Pantheon Macroeconomics consultancy, said.