The Bank of England is now facing a new problem as a result of falling inflation

CPI on track to reach Andrew Bailey’s spring target – when will interest rate drop?

Andrew Bailey is being pressed. Andrew Bailey is under pressure.

Bailey warned that the last mile in the battle against inflation was the most difficult.

Three months ago, policymakers believed that the Bank’s target of 2pc for inflation as measured by consumer prices index (CPI) would not be reached until 2025.

The UK is on track to reach its target by April. This would make it the first G7 economy to achieve this goal .

The question is no longer if, but rather when. Policymakers are preparing for the next interest rate decision to be made by the Bank on Thursday.

Bailey has insisted that it’s too early to talk about a cut and the majority of economists expect the Bank to hold rates at 5.25pc on Thursday for a 4th consecutive meeting.

The context of this meeting is quite different from previous ones.

The Bank’s projections for November were based on a 5pc drop in oil prices due to a big fall in energy costs .

Deutsche Bank projects that this could reduce the Bank’s CPI headline projections by up to 0.15 percentage point.

The Bank’s forecasts will be affected by the dramatic fall in gas prices. They are now 25pc lower than the levels they assumed for November.

Deutsche Bank estimates that this undershoot could knock 1.4 percentage points from the headline rate alone in 2024.

Michael Saunders is a former Bank rate-setter. He says that the gap between the forecasts and the actual inflation figures for December has already been the largest in the last 20 years.

In November, the Bank predicted that headline inflation in December would drop to 4.6pc. In reality, it was 4pc. This suggests that the Bank may be forced to make major downward revisions in its latest economic projections, which are due out this week.

Although the inflation increased slightly last month and may increase again in January due to a slight rise in the energy cap, the majority of City economists still believe that the only way down is up.

Saunders now works at Oxford Economics. He says, “Inflation is much lower than their forecast and will continue to fall short.”

He expects inflation to average around 1.6pc during the second quarter 2024, as opposed to the Bank’s November forecast which was 3.6pc.

By Easter, energy bills will be significantly lower due to the reduction in wholesale energy prices. Cornwall Insight is a respected consultant in the industry. They believe that average bills will drop by 16pc, to £1,620, from £1,928.

Even though traders have been tempering their expectations, the falling inflation has led to a rush of bets for rate cuts.

Investors believe that the first rate reduction will occur in May and have priced in four rate cuts for this year.

The economic outlook is still uncertain. Britain may already be in a recession. Meanwhile, tensions at the Red Sea remind us that inflation is still rife.

Sir Charlie Bean, former deputy of the Bank, believes that the future outlook for wages will determine the direction in which the policy is taken. Consumer confidence has grown and pay packets are starting to increase in real terms. If the Bank withdraws from its high interest rates too quickly, this could rekindle the flames and cause inflation to abate.

Sir Charlie anticipates that policymakers have spent the past week parsing the survey conducted by Threadneedle’s agents, the Bank’s eyes and ear across the country.

This important piece of research is a reliable source for policymakers to get a sense of the outlook for wage increases in the coming year.

“The bargaining power of the labour force is still fairly good,” said Sir Charlie. “This is why excessive pay growth could continue for some time.”

The average weekly earnings are barely changed since last summer, and the number of vacancies continues to fall. However, unemployment is still near historical lows, and employers continue to face severe skills shortages.

The majority of pay negotiations are in full swing. According to XpertHR, the majority of pay agreements will be implemented before Spring. A quarter of them were completed in January, and nearly half in April.

The Bank will be looking closely at smoke signals regarding pay, especially since official job data is not reliable.

Sir Charlie believes that policymakers shouldn’t talk about rate reductions until the pay growth slows down further.

It’s vital that the rate of pay increases falls to a sustainable level.

The recent inflation rate of 6pc is incompatible with the target. They won’t start loosening the policy until they’re sure that underlying inflation is in line with headline inflation.

Sir Charlie thinks that the financial markets are ahead of themselves by betting on rate cuts. However, he believes that the next move will be more likely downwards than upwards.

It depends on the outcome of the data. “Personaly, I think any rate reductions are more likely to occur in the second half than the first.”

Saunders, a former member of the Bank’s Monetary Policy Committee, says that policymakers shouldn’t talk about rate cuts until they are ready.

He thinks the Bank’s challenge will be to convey a stronger and longer message, while acknowledging that rates are likely going to fall this year.

He says that they are now focusing more on the sustainability of inflation returning to target.

The analogy of a car driver has long been favored by central bankers. At the moment, the foot is firmly planted on the brake.

“You can let off the brake but it’s not the equivalent of putting your foot down on the accelerator.”

Signals are important for interest rates, according to history.

Since 1997, the MPC has made 14 changes to the Bank Rate. Joe Maher, Capital Economics, says that in the lead-up to 13 of the turning points one or more MPC member jumped the gun. The majority then followed within four meetings or less.

HSBC believes Swati Dhingra will vote for a rate reduction this month.

She has voted for the interest rate to be held at 3pc.

Dhingra, however, has warned for months about the “risks associated with overtightening policies”.

Maher claims that the current MPC divergence is the largest ever recorded. The number of dissenting vote has increased and been more frequent than at any other time in the last 12 meetings.

Since September 2021, the MPC hasn’t made a unanimous decision on interest rate.

Martin Weale served as a member of the MPC from 2010 to 2016. He says that the risks associated with cutting too quickly or too slowly are delicately balanced.

He continues: “There will probably be rate reductions this year.” There’s a chance that one will come in May. However, I wouldn’t call it a certainty.

The MPC’s primary objective is to reduce inflation. The instructions of the Chancellor state this. If I was still in the committee, I would be paying attention.”