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Fall in inflation doesn't mean we should cut interest rates, Bank of England's Pill says

Bank of England’s Chief Economist Huw Pill (REUTERS)
Bank of England’s Chief Economist Huw Pill (REUTERS)

The recent fall in inflation towards the 2% target is not necessarily enough reason for the Bank of England to start cutting interest rates, and it would be better to cut too late than too early, the Bank of England’s chief economist Huw Pill said today.

Speaking at the University of Chicago, the economist - one of nine members of the Monetary Policy Committee that sets interest rates - said that little had  changed in his view of the inflation and interest rate situation since late March.

But he noted last week’s publication of Nobel prize winner Ben Bernanke’s review of the Bank of England’s forecasting methods. The ex-fed chair Bernanke found a number of  shortcomings in how the Bank attempted to project key data like the inflation rate, which may have contributed to its failure to predict the extent to which inflation rose in 2022 or its slow fall at the start of 2023.

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Pill said: “After several years of above target inflation rates and given the threat of persistent inflation dynamics becoming embedded in expectations, in my view there are greater risks associated with easing too early should inflation persist rather than easing too late should inflation abate.

“This assessment further supports my relatively cautious approach to starting to reduce Bank Rate.”

Towards the end of 2023, inflation started to fall more quickly, and it is widely expected to drop below the 2% target when April inflation figures are published next month. The Bank of England aims to set interest rates at a level that means inflation stays around 2%.

But Pill said this fall doesn’t mean the bank must cut rates. He said much of the fall in inflation wasn’t due to Bank policy, and that Threadneedle Street is focused on the “persistent component” of price rises. The Bank has repeatedly flagged the much higher rate of services inflation, which is still 6.0%, as a sign that underlying factors point to inflation rising again and getting stuck above 2%. In the US, inflation has been stuck above target despite falling to 3% much sooner than it did in the UK. Some economists fear the UK could be in for the same.

Pill said: “Much of the decline in headline inflation is attributable to external (or exogenous) developments that are little influenced by the MPC’s policy decisions. Seeing headline inflation fall towards target is therefore not a sufficient condition for withdrawing monetary policy restriction. This is inherent to the MPC’s current framework and its focus on the persistence of inflation.

“As such, it is the evolution of the persistent component, which is influenced to a significant extent by the stance of monetary policy, that should drive policy decisions.

“The tentative decline in the persistent component of inflation that we have seen thus far owes to the restrictive stance of monetary policy the MPC has established. Any decline in inflation persistence we are seeing is therefore not a reason to think restrictiveness is no longer required. Rather it is an illustration that the restrictiveness of monetary policy is starting to have its desired effect.”

However, some economists have been less concerned about the persistence of inflation. Consultancy Capital Economics forecasts that the UK’s inflation rate will be below target for all of 2024 and 2025. If so, the Bank is likely to speed up its rate-cutting.

Pill said: “Much of the decline in headline inflation is attributable to external (or exogenous) developments that are little influenced by the MPC’s policy decisions. Seeing headline inflation fall towards target is therefore not a sufficient condition for withdrawing monetary policy restriction. This is inherent to the MPC’s current framework and its focus on the persistence of inflation.

“As such, it is the evolution of the persistent component, which is influenced to a significant extent by the stance of monetary policy, that should drive policy decisions.

However, some economists have been less concerned about the persistence of inflation. Consultancy Capital Economics forecasts that the UK’s inflation rate will be below target for all of 2024 and 2025. If so, the Bank is likely to speed up its rate-cutting.

Following the speech - and PMI data this morning that pointed to surprisingly strong service sector growth and a sharp resurgence of input cost inflation for businesses - City traders reduced their bets on interest rate cuts in the near future. A cut in May had been seen as a one-in-five chance, according to markets, but the implied probability now is closer to one-in-twelve. A June cut is still seen as a strong possibility, but the implied chance dipped below 50%.

Pill came under fire last year when he said that workers should avoid taking pay rises, in order to keep inflation under control.