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Bank of England set to hold interest rates despite inflation hitting 2% target

Bank of England
Markets widely expect the Bank of England to keep interest rates at a 16-year high of 5.25%. (Reuters / Reuters)

The Bank of England is set to leave interest rates unchanged at the 16-year high of 5.25% when it meets this Thursday even as inflation hit the 2% target.

The Office for National Statistics figures show the Consumer Prices Index (CPI) dropped to 2% in May, down from 2.3% in April.

The figure indicates that prices are still rising, but at the slowest pace since July 2021. It comes following a sustained period of high inflation in the UK, which peaked at 11.1% in October 2022 – the highest level since 1981.

The Bank of England will look at these numbers on Thursday to decide what to do about interest rates.

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Services inflation, a key metric that is closely watched by the Bank of England, however, slightly missed analysts' expectations, coming in at 5.7% on the year versus market expectations of 5.5%.

Experts have noted that last month's inflation data, particularly the services sector inflation which exceeded the Bank's expectations, will have been a key consideration for the Bank. This measure, which examines price increases across the sector, is "overwhelmingly what is driving policy decisions right now", according to economists at ING.

Thomas Pugh, economist at RSM UK, said: "Services inflation, which is a better measure of underlying price pressures in the economy than headline inflation, missed expectations again, only slowing to 5.7% against expectations of 5.5%.

"This will raise concerns on the MPC that underlying price pressures in the economy aren’t slowing as quickly as expected and makes an August interest rate cut less likely."

Still, the economist is not ruling out an August cut. He added: "We expect inflation to fall below 2% in June, setting the stage for the MPC to cut interest rates in August.

"Inflation is likely to average a little above 2% for the rest of the year giving the Bank plenty of room to deliver rate cuts.

"Our base case is still for interest rates to finish the year at 4.5%, but the risks have clearly shifted to fewer cuts this year."

Read more: UK inflation drops to Bank of England's 2% target

James Smith, research director at the Resolution Foundation, also warns about services price inflation being higher than expected. He said: “And while headline inflation is back to normal levels, domestically-driven services-price inflation remains elevated. This inflation will worry the Bank of England, and may give pause for thought when it comes to cutting interest rates.”

Martin Sartorius, principal economist at the Confederation of British Industry, said the drop in inflation “sets the stage” for policymakers to cut interest rates in August.

Thursday's decision is all but certain to leave interest rates unchanged as most economists think it is very unlikely that the Bank of England would be willing to start cutting interest rates in the middle of an election campaign.

Threadneedle is in a holding position as it abides by the rules of the pre-election campaign period, meaning its policymakers cannot make any speeches or public statements. This period of silence makes a rate cut in June an unlikely move.

Sandra Horsfield, an economist for Investec, said this matters because were policymakers to “surprise the market” with its decision on Thursday, it would not be in a position to “correct any misinterpretations” about its rates decision until after the general election, which is on 4 July.

“Why rock the boat, when there is no need for haste and no opportunity to steady it?,” she asked.

Interest rates are currently sitting at 5.25% and have been held at this level since August 2023.

Analysts at AJ Bell suggested that the Bank's task may have been slightly complicated by the announcement of a general election for 4 July.

They said: "Governor Andrew Bailey and his colleagues on the MPC may not wish to act in any way that could be seen as favouring one political party over another in the run-up to July's poll."

Read more: What is a stock split and why are big tech companies opting for it?

Policymakers last month signalled the possibility of a rate cut as early as June, but investors now see little chance of that, after economic growth, wage expansion and services inflation all came in higher than expected.

Money markets suggest that 1 August is still the most likely date for the Bank of England to make its first rate cut since 2020.

Investec is predicting that the first rate cut could occur in August, but that two committee members, Swati Dhingra and Dave Ramsden, are likely to vote again in favour of a cut on Thursday.

A Reuters poll showed 63 of 65 economists thought a first cut would not come until 1 August. Most also expected another reduction before the end of the year.

Taylor Swift performs on stage during during 'The Eras Tour' at Anfield on 13 June, in Liverpool, England.
Taylor Swift performs on stage during during 'The Eras Tour' at Anfield on 13 June, in Liverpool, England. (Gareth Cattermole/TAS24 via Getty Images)

Singer Taylor Swift is not usually associated with UK interest rates but economic impact her tour is having could be enough to defer a possible September interest rate cut from the Bank of England, investment bank TD Securities said in a note.

“We still anticipate a BoE cut in August, but the inflation data for that month might keep the MPC (monetary policy committee) on hold in September,” the bank’s macro strategist, Lucas Krishan, and its head of global macro strategy, James Rossiter, said.

However, as hundreds of thousands of dedicated Swifties flock to London in August to see Taylor Swift perform, the economist boost might be enough to make Threadneedle Street think twice about when to cut rates.

For the duration of Taylor Swift's European Eras tour, hotel prices across concert cities are expected to surge 44% on average, according to a recent report by Lighthouse.

Some cities such as Liverpool, Warsaw and Stockholm, were expected to see hotel prices jump more than 100% during this time.

In the UK, according to Barclays, Taylor Swift fans are likely to spend about £848 on items including tickets, accommodation, clothes and travel.

“A surge in hotel prices then could be material, temporarily adding as much as 30bps to services inflation (+15bps on headline),” Krishan and Rossiter warned.

The main reason behind high interest rates is to bring inflation down, but with price increases slowing down, why is the Bank of England not pushing forward with cuts?

Read more: When will interest rates fall and what should you do?

While UK inflation eased to 2% in May, hitting to the central bank's target, from a peak of 11.1% in October 2022, the Bank will have taken note of last month’s inflation data, with services sector inflation still coming in ahead of expectations.

Susannah Streeter, head of money and markets, Hargreaves Lansdown, said: “But it doesn’t look like the Bank of England will join the celebratory party immediately and cut interest rates. Policymakers still have their eye on hot wage inflation, with earnings including bonuses still running at 6%, at the last count. However, a cut in August is still a very real possibility.’’

Read more: UK interest rates set to remain on hold ahead of general election

The tally of global interest rate cuts in 2024 stands at 70, according to website CBRates, after the reductions from the Bank of Canada and the European Central Bank this month.

The US Federal Reserve last week kept its key interest rate unchanged and signalled that just one cut is expected before the end of the year.

“Although the Bank of England is now expected to follow the ECB’s example and move before the US Federal Reserve, the degree to which UK rates can diverge from those in America could still limit the MPC’s room for manoeuvre” AJ Bell said.

“Too big a gap between the UK base rate and the Fed funds rate could suck capital out of sterling and into dollars, weakening the British currency, at the risk of boosting inflation thanks to how the UK buys and imports more than it sells and exports,” analysts at AJ Bell added.

The Bank of England will announce its decision on interest rates this Thursday at noon.