Bank of England Cuts Interest Rates Amid Inflation Control: Market Reactions
The Bank of England made a pivotal move at its August meeting, cutting interest rates by 0.25 percentage points to 5%. This adjustment, the first since March 2020, comes after a year of stable rates and reflects signs of easing inflationary pressures.
A Divided Decision
The decision to reduce the Bank Rate was narrowly passed by policymakers with a 5-4 vote, indicating a significant divide within the committee regarding the appropriate monetary policy stance. The narrow majority favoured the cut as a strategic response to the current economic environment.
Inflation and Economic Outlook
Ongoing declines in price pressures drove the rate cut. The headline inflation rate held steady at 2% year-on-year in June 2024, matching May's figures and marking the lowest levels since 2021. Core inflation, which excludes volatile energy and food prices, remained at 3.5% for the second consecutive month, the lowest since October 2021.
The Bank of England's statement highlighted that restrictive monetary policy has been weighing on economic activity, resulting in a softer labour market and reduced inflationary pressures. The Monetary Policy Committee (MPC) expects that declining headline inflation and normalising inflation expectations will lead to weaker pay and price-setting dynamics. We anticipate that the economy will develop a margin of slack as GDP falls below its potential and the labour market continues to ease.
However, there remains a risk of medium-term inflationary pressures from second-round effects. The Bank of England projects a median Consumer Price Index (CPI) of 2.4% in one year, down from 2.6% in March. The forecast for the two-year horizon is 1.7%, down from 1.9% in March and 1.5% for the three-year horizon.
Despite these projections, the Bank has not provided explicit guidance on future rate paths, emphasising the need for restrictive monetary policy to mitigate the risks of inflation exceeding the 2% target in the medium term. The MPC will assess the appropriate degree of monetary policy restrictiveness at each meeting while closely monitoring inflation persistence.
Market Reactions
Following the rate cut announcement, the British pound fell sharply, declining by 0.74% to 1.2760 against the US dollar, marking the largest one-day drop since April. The pound dropped more than 0.6% against the Japanese yen, hitting a four-month low. The euro gained 0.4% against the pound, breaking above the resistance from its 200-day moving average.
Gilt yields experienced a decline, particularly in shorter-dated securities, with the two-year gilt yield decreasing by 5 basis points to 3.76%, returning to levels seen in May 2023.
UK equities reacted positively to the rate cut, with the FTSE 100 index rising 0.2% as investors welcomed the lower borrowing costs for British corporations. Several companies saw significant gains, with strong quarterly results and revised guidance boosting investor confidence.
The Bank of England's decision to cut interest rates reflects a strategic response to moderating inflation and current economic conditions. Despite a divided vote among policymakers, the rate cut aims to support economic activity while maintaining caution with forward guidance. The Bank remains vigilant, leaving room for future adjustments based on evolving data and signalling its commitment to balancing inflation control and economic stability.