The Bank of England governor has signalled markets are right to expect more than one interest rate cut this year, saying he is increasingly confident inflation is heading towards target.
Andrew Bailey told the Financial Times that rate cuts were “in play” at future meetings of the BoE Monetary Policy Committee amid signs that tighter policy had quelled the risk of a wage-price spiral.
“It’s like the Sherlock Holmes dog that doesn’t bark. If the second-round effects don’t come through, that’s good because monetary policy has done its job,” he said.
“We have an increasingly positive story to tell on that,” Bailey added. “The global shocks are unwinding and we are not seeing a lot of sticky persistence [in inflation] coming through at the moment. That is the judgment we have to keep coming back to.”
Major central banks including the Federal Reserve and European Central Bank have put summer interest rate reductions on the table as officials become increasingly optimistic that they have vanquished the worst inflationary outbreak for a generation. The MPC met this week and held UK rates at 5.25 per cent as official figures showed inflation has receded to 3.4 per cent, its lowest level in more than two years.
Speaking in an interview at the BoE after the meeting, the governor struck a more optimistic tone about the UK economy, stressing how small the technical recession in the second half of last year had been and pointing to signs that an upturn is now in train. “This is obviously good news,” he said.
Strikingly, the UK was “effectively disinflating at full employment”, Bailey added, underscoring how unusual this situation was, given that battles with inflation have typically been won at the cost of higher unemployment.
It did mean the BoE was walking a “narrow” path in setting policy as it tried to assess how tight the labour market was, he said.
Bailey’s upbeat comments will be welcomed by Prime Minister Rishi Sunak, who is building his election strategy around hopes of an improving economy, including falling inflation and a cut in interest rates before polling day.
Sunak claimed this week that 2024 would be the year the economy “bounces back” and urged Conservative MPs to hold their nerve and stick with his economic plan. An election is expected in the autumn.
While headline inflation has receded sharply, the BoE is closely watching wages and prices in the services sector, where price growth is still more than 6 per cent.
Bailey confirmed that there was a range of views in the MPC about how reassuring these indicators had been, as he stressed the BoE’s job on inflation was not yet done. “Some people are more comfortable with the evidence they are beginning to see, and others feel, no, we are further off from being confident.”
Asked if he was in the former category, he said: “What we are seeing is encouraging to me.”
Bailey declined to say when or by how much interest rates might be cut this year, while noting that markets are now putting greater odds on an initial reduction in June following the MPC meeting.
But he added: “The fact that we have a curve that has cuts in it for the year as a whole is not unreasonable to me.” Asked if all the upcoming MPC meetings were live when it comes to possible policy moves, he confirmed: “All our meetings are in play. We take a fresh decision every time.”
The BoE was badly stung by failures to forecast the magnitude of the inflationary upsurge that began after the end of the Covid-19 lockdowns, and which gathered greater strength with Russia’s war on Ukraine — an event that delivered a “huge shock” for Europe, in Bailey’s words.
But the governor said this experience, which saw UK inflation hit double-digit levels in 2022, was not making the central bank more cautious about reducing interest rates now.
“Credibility can also be affected by waiting too long,” he said. “I would not say we or I have become decisively more or less cautious. We have learnt a lot.”
Bailey insisted that he did not need to see inflation drop to 2 per cent, the BoE’s target level, before cutting rates, but he said the key point was “you need to see you are on the way”.
Similarly, policymakers should not wait for annual growth in wages and services prices to halve from current levels exceeding 6 per cent. “You need to have confidence that it’s heading in that direction,” he said.
While central bankers were worried last year that an upward spiral between high wages and prices could develop — also known as “second-round effects” — Bailey confirmed he was becoming less concerned about this risk. “One of the things it tells us is that monetary policy has done its job,” he said.
“I am more confident, yes,” he added. “This mechanism — headline inflation, expectations, price-setting, wage-setting — is showing signs of working as you’d expect it to work.”
The more benign outlook is a marked contrast to the tumultuous conditions that have accompanied Bailey for the bulk of his time as governor: a four-year period that has in his words involved some “heavy-duty firefighting”.
The Leicester-born central banker started his eight-year term as governor in March 2020 just as the Covid-19 crisis began to buffet the global economy and financial markets, prompting the BoE to launch a bond-buying effort as part of a range of emergency measures aimed at propping up the UK economy.
Bailey, who had moved back to the BoE after a politically fraught spell as head of the Financial Conduct Authority, won plaudits for his rapid response and cool handling of the Covid-related conflagration.
But the acclaim quickly subsided after the lockdowns ended and it became clear the UK was facing a brewing inflation threat and a cost of living crisis.
The BoE, like many of its counterparts around the world, insisted that any flare-up in price growth was likely to be transitory, predicting a one-off increase in consumer prices rather than persistently higher inflation rates.
Asked about those forecasting failures, Bailey insisted that “everybody” had got the scale of the inflationary upsurge wrong. The biggest problem the BoE faced, he added, was understanding how the jobs market would react after the end of the government’s Covid-era furlough scheme.
He is awaiting a review commissioned by the BoE’s court of directors from former Federal Reserve chair Ben Bernanke into the central bank’s forecasting and communications.
One likely outcome, officials expect, is for the BoE to focus on alternative “scenarios” for future economic developments, to illustrate how policy might react. At the same time, the BoE would ditch its traditional “fan chart” forecast, which communicates uncertainty by ranges of probabilities.
Bailey confirmed that the fan chart was likely to “get retired” in the aftermath of the review. But he said the BoE would have to think hard about how it deployed alternative scenarios in its communications. The markets could become frustrated or confused if it was unclear what the central bank sees as the most probable outlook, he said.
Investors will also be watching closely to see if Bernanke suggests the introduction of a so-called dot plot similar to that used by the Fed, under which officials set out their interest rate expectations.
Bailey hinted the idea was under consideration but suggested he was not convinced whether it was the right way for the BoE to go. “I’m certainly in two minds about the dot plot,” he said. One risk was that individual policymakers in the UK would be pressured to reveal their individual rate expectations, he warned.
That said, the Bernanke review presented a “once in a generation” opportunity for the BoE to look at its internal forecasting processes. “The big questions follow from ‘how do you deal with shocks like wars?’ and ‘if we are living in a more unstable world at the moment how do we gear ourselves up to handle that?’”
In an institution that is notoriously hierarchical, Bailey also said he wanted to ensure there was an environment where BoE staff were unafraid of challenging top officials. It was important, he said, to have an environment where the staff can tell the MPC “you are barking up the wrong tree”.