Bank of England To Keep Rate Cut Expectations At Bay: Pantheon Macroeconomics

Image © Pound Sterling Live

The Pound could be set for deeper falls over the coming weeks if the Bank of England allows financial markets to bring forward the expected timing of the first interest rate cut of 2024.

But, the Bank will avoid such an outcome when it meets this Thursday, according to one of the UK's best economists.

Samuel Tombs, Chief UK Economist at Pantheon Macroeconomics, says the market's takeaway from Thursday's interest rate decision and guidance will be that interest rates will be maintained at current levels for an extended period.

Tombs, who has frequently been judged the UK's most accurate economics forecaster, says the Bank will opt to keep interest rates unchanged, and "changes to the MPC’s forecasts and guidance will be more newsworthy this time."

The Bank uses its forecasts and assumptions about inflation to guide the market's assumptions on the future direction of interest rates.

For example, if it forecasts inflation will be well below the 2.0% target by 2025, then the market will assume it believes it will be in a position to cut interest rates in 2024.

The finessing of the forecasts can therefore have a strong signalling effect that moves UK bond yields and, ultimately, the Pound.

The Bank's existing modal forecast - where interest rates are assumed to remain unchanged - is for CPI inflation to reach 3.4% in 2024 and 1.8% in 2025.

(This model disregards the market's assumptions for the direction of Bank Rate. The rule of thumb is that the higher inflation rate expectations are, the lower the inflation forecast).

Pantheon Macroeconomics thinks the MPC will keep its modal forecast for CPI inflation in 2025 slightly below the 2% target.

"A sub-2% target forecast for inflation would usually signal that interest rates will fall soon, but the MPC likely will incorporate net upside risk into its forecast so that its mean projection will be higher than its modal projection," says Tombs.

Image courtesy of Pantheon Macroeconomics.

An alternative inflation forecast - this time based on market-based assumptions for Bank Rate - should be slightly higher than in August, given expectations for the peak in Bank Rate have fallen substantially.

Pantheon Macroeconomics expects the Bank's forecasts will signal that it sees some scope to cut interest rates eventually, but not by much and not soon, given the risks to the inflation outlook.

As such, the Bank is expected to retain a commitment to keep monetary policy "sufficiently restrictive for sufficiently long" and will warn again that "further tightening in monetary policy would be required if there were evidence of more persistent inflationary pressures".

"It's too soon to expect the MPC to pivot to more dovish language," says Tombs.

If this is the case, and the market buys the message, the Pound can stay supported.

However, we note that should one of the Monetary Policy Committee vote for a rate cut, the entire communication effort of 'higher for longer' will be undermined. This is a key risk to the Pound this week as analysts at Barclays say MPC member Swati Dhingra will vote for a cut.

Beyond this week's Bank of England guidance, Pantheon Macroeconomics thinks CPI inflation will fall quickly from here, kick-starting a sequence of 25bp rate cuts at alternate meetings from May.

This is well ahead of the market's existing expectation for the first rate cut to fall in September, implying a significant rerating in bond yields that could undermine the Pound's outlook.