Inflation is 3.6%, so why is the Bank cutting rates?

• Why inflation rose more than expected in June

The rate came down again in early February this year, when the latest inflation figure was 2.5 per cent (December 2024), and again in May, by which time the most recent figure for price rises was March’s 2.6 per cent.

Before that, when the MPC cut Bank rate to an all-time low of 0.1 per cent in two steps in March 2020, with the onset of Covid and in anticipation of the first lockdown, inflation was 1.7 per cent and heading temporarily even lower.

So, for the Bank to reduce interest rates when inflation is running at 3.6 per cent, well above target, takes us into new territory in relation to recent rate decisions, though it is not entirely unprecedented. During the financial crisis in 2008-09, eight interest rate cuts, some quite chunky, took us all the way from 5.5 to 0.5 per cent. Some of those occurred against a backdrop of high inflation, 5.2 per cent in the autumn of 2008, but the Bank had bigger fish to fry; the economy needed support at a time when the banks were falling like ninepins.

Things are very different now. The economy has been growing only weakly in the past three to four months but there is no sign of an imminent recession. The latest Lloyds Bank business barometer showed that business confidence last month was at its highest for ten years. Hiring intentions also “soared” to a ten-year high, according to the bank. A different view was provided by the Institute of Directors, which said on Friday that confidence had fallen to its lowest point since the index began in 2016.

Why cut rates? The Bank has to look forward, not back, but one way of answering that question is to look at what the MPC was saying last time, when it decided in June to leave the rate unchanged at 4.25 per cent. It was a split vote, 6-3, and there may also be a split this week.

For the six who voted to leave interest rates unchanged, the fact that inflation was about 3.5 per cent, and likely to remain there for the rest of the year, was a reason not to rush into a cut. But even they saw “greater signs of disinflationary pressures from the labour market” and expected inflation to be “falling back towards the target from next year”.

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

They were not taking that fall in inflation for granted, warning that the risks around its medium-term path were “two-sided”. Sure enough, the British Retail Consortium warned last week that food price inflation could hit 6 per cent by the end of the year because of higher costs, including rising taxes. The Bank will take that into account, though food commodity price pressures appear to be easing globally.

But for most of the people in this group of non-cutters in June — which included the governor Andrew Bailey; the deputy governor with responsibility for monetary policy, Clare Lombardelli; and the Bank’s chief economist, Huw Pill — it appeared to be a case of when, not if, for further rate cuts.

The three dissenting members of the MPC did not want to wait and thought it right to cut by a quarter of a point in June — and are set to do so again this week. They believed wage growth was coming down faster than expected, that “slack” was opening up in the labour market and that keeping policy restrictive for too long would risk inflation undershooting the 2 per cent target in the coming years.

Some would say that after a period in which inflation has been overshooting — spectacularly so three years ago — a period in which it undershoots to compensate would be no bad thing. But the Bank operates on a “what’s done is done” approach. It has no mandate for targeting lower inflation than 2 per cent to make up for any previous overshoots.

Indeed, the governor is required to write letters of explanation and justification if inflation deviates by more than a percentage point from the 2 per cent target. Andrew Bailey wrote to Rachel Reeves in June to explain why inflation was running at more than 3 per cent.

The key point made by the Bank’s interest rate “doves”, however, and the key to understanding the MPC’s approach, is one that people outside the process and those unfamiliar with monetary policy find hardest to understand. This is that policy can remain restrictive even as interest rates are being cut.

There were 14 successive interest rate increases between December 2021 and August 2023, which took Bank rate from 0.1 to 5.25 per cent, and on this view they took policy into highly restrictive territory, after years in which the official interest rate had been close to zero.

Four interest rate reductions over the past 12 months have eased the degree of restrictiveness but not removed it. The Bank’s rate-cutters would see it as easing off on the brake, not pressing down on the accelerator. That raises the question of by how much rates should be cut before monetary policy is no longer restrictive.

The answer appears to be somewhere below the 4 per cent level that is expected this week. And that it is expected does not mean it will not be controversial.

PS

Staying with the Bank and things that are hard to understand, I normally pride myself on being able to explain economic concepts in an understandable way. But, among some readers and on one particular issue, I must admit it is becoming a struggle. The issue is quantitative easing (QE) and quantitative tightening (QT), on which I wrote last week. People got in touch politely to say that they were still befuddled after reading it.

It may be that there is something badly wrong with a policy that cannot be easily explained, but let me hand this one over to the Bank and the way it explains it on its own website.

“QE involves us buying bonds to push up their prices and bring down long-term interest rates,” it says. “In turn, that increases how much people spend overall, which puts upward pressure on the prices of goods and services. In total, we bought £895 billion worth of bonds. Most of those (£875 billion) were UK government bonds. The remaining £20 billion were UK corporate bonds.

“At the moment, inflation is above the 2 per cent target, so we have raised interest rates to bring it back down again. We have also been reducing the stock of bonds we bought during QE — a process sometimes called ‘quantitative tightening’. The MPC decided to begin doing that in February 2022.

“The money we used to buy bonds when we were doing QE did not come from government taxation or borrowing. Instead, like other central banks, we can create money digitally in the form of ‘central bank reserves’. We use these reserves to buy bonds. Bonds are essentially IOUs issued by the government and businesses as a means of borrowing money.

“Now that we are reversing QE, some of those bonds will mature and we are selling others to investors. When that happens, the money we created to buy the bonds disappears and the overall amount of money in the economy will go down.”

Is that any clearer? I hope so. One possible hurdle may have been the mention of central bank reserves. On this, over to the governor, and a speech he made last year, in which he said: “Central bank reserves, the deposits that commercial banks hold at the central bank, serve as the ultimate means of settlement for transactions in the economy. Central bank reserves, in other words, are the most liquid and ultimate form of money.”

If you are still confused, I may have to direct you to the Bank on Threadneedle Street. You can’t miss it.

david.smith@sunday-times.co.uk