(Bloomberg) — When central banks start cutting interest rates, they typically act quickly. The Bank of England could take a more cautious path if its nine-member Monetary Policy Committee decides it is time to cut borrowing costs.
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What’s different about this cycle is that it’s a recovery rather than a recession. Official figures on Friday showed Britain emerged from a mild recession with its strongest quarterly growth since the end of the pandemic.
This is in sharp contrast to the previous three interest rate cutting cycles (1998, 2001, and 2008), when central banks acted to support growth. Each time, it moved faster and cut sharply.
This week, BOE Governor Andrew Bailey acknowledged that the MPC is heading into largely uncharted territory. “Most of the reduction cycles are actually caused by some kind of shock or something, rather than the natural cycle of ‘hitting the top and now going down the limit curve,'” Bailey said. He spoke to Bloomberg TV after Thursday’s decision to keep the key policy rate at 5.25%, the highest level in 16 years.
Asked if there was much precedent for what the bank was about to embark on, he said: “I’ll warn you, there isn’t much precedent.” What’s about to happen is “in some ways very interesting and something we’ve been looking at,” he added.
Investors are betting that the first rate cuts since the pandemic will begin by a quarter of a point in August, followed by further cuts around November. Mr Bailey himself said cuts at the next meeting were “neither ruled out nor a fait accompli”, implicating June.
If the BOE takes drastic measures, British economists predict a rapid series of rate cuts. The median forecast in a Bloomberg survey of 44 people was for a four-quarter point decline in five meetings between June and December. Bailey was more cautious. “We have no preconceptions about how fast or how much mileage we can reduce,” he said.
The deep cuts would help Chancellor Rishi Sunak, who is hoping for a “boosting factor” in the economy ahead of a widely expected election in the autumn. At the moment, his Conservative Party lags behind the Labor opposition in opinion polls, continuing the fallout from last year’s underperformance.
At the BOE, policymakers will seek to reduce “restrictive” borrowing costs imposed to control inflation rather than stimulate growth. The plan is to carefully lower interest rates to neutral levels. But no one knows where it is, so authorities will have to fumble around. Outgoing Lieutenant Governor Ben Broadbent said Thursday it’s “something you learn over time.”
The risk is not a sudden economic collapse but a resumption of inflationary pressures. Even before Friday’s unexpectedly strong official gross domestic product (GDP) figures for the first quarter were released, the BoE had revised up its UK growth outlook. The bank said strong real wage increases have boosted consumer spending this year, and housing market sentiment has also improved.
Dan Hanson, chief U.K. economist at Bloomberg Economics, said the BOE would not bring interest rates back to normal levels after a recession, rather than looking at past rate-cutting cycles for clues about how policy might develop. It may be more appropriate to compare the period during which interest rates were raised in order to bring them back.
“It could be similar to what happened during recoveries from past economic downturns, where interest rates tended to rise much more slowly than they cut,” he said. His central issue remains a rapid series of rate cuts to 4% starting in June.
All of this suggests that the BOE may move slowly, pulling back at one meeting and pausing at the next to see how the data develops. Alan Monks, UK economist at JPMorgan, predicts such a stop-start trajectory.
He believes a cautious approach is needed to adjust the glide path to a neutral one that pushes prices down without hurting growth. That would have the added benefit of preventing UK interest rates from diverging too much from US rates, where the Federal Reserve has signaled a policy of “high interest rates for an extended period of time,” he said.
Mr. Bailey argued that the Fed is dealing with more persistent inflation than the U.K. because the U.S. economy is overheating. Mr Monks worries that if the Fed stops raising rates while the BoE cuts them, the pound will weaken and British inflation will soar.
“Reducing inflation will provide gradual easing, and a recession will be needed to encourage faster rate cuts,” Monks said. “The Fed is important not only because of currency effects, but also because of potentially relevant information about the underlying processes.”
He believes there are lessons yet to be learned about how the economy became more resilient to high interest rates and how a tight labor market poses greater inflation risks than before.
Paula Bejarano Calvo, an associate economist at the National Institute of Economic and Social Research, also said the company is slowly moving ahead in case underlying inflation turns out to be stronger than expected, or if geopolitical risks in the Middle East cause prices to rise again. We expect that interest rates will be cut in stages. “It would be better to pause rate cuts than to reverse them,” he said.
For now, British economists still expect the BoE to move quickly to move monetary policy out of the restricted zone and towards the widely considered upper end of the neutral range of 3.25% to 4.25%. In any case, the BOE will need to strike a delicate balance.
—With assistance from Andrew Atkinson and Francine Lacqua.
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