Don't cut rates too fast says Bank of England's top economist

In what seems like just a few minutes since Andrew Bailey sent mortgage borrowers hopes soaring, and the pound plunging, Huw Pill, the Bank of England’s chief economist, has said that Interest rates should gradually decrease but remain elevated for an extended period in order to combat persistent inflation.

His comments signal growing differences of opinion among the central bank's top policymakers – making it difficult to predict just what mortgage rates are likely to do next.

Speaking at the Institute of Chartered Accountants in England and Wales (ICAEW), Pill predicted that the UK economy would enter a “virtuous cycle” of stabilising inflation over the next year. However, he cautioned that this would only happen if a "restrictive monetary policy stance" is maintained to keep inflationary pressures in check.

Read more: Pill’s speech to ICAEW

He emphasised that while interest rates would eventually need to decrease, it must be done in a way that still ensures inflation is controlled effectively, stating, “Bank rate will need to fall over time but at a pace that ensures sufficient restriction is maintained in the transition for UK inflation to reach target in a lasting and sustained manner, not just fleetingly or in passing.”

Pill also warned of the possibility of deeper structural shifts in the UK economy that could lead to more persistent inflation, necessitating a longer-lasting monetary policy response to keep inflation at target levels. He suggested that the Bank of England’s assumed neutral interest rate—which balances growth and inflation—may be too low.

These comments contrast with those of the Bank of England's governor, Andrew Bailey, who recently suggested that the central bank could take a “bit more aggressive” approach to loosening monetary policy if inflation continues to decline.

Bailey’s remarks caused the pound to experience one of its biggest drops against the dollar since the aftermath of Liz Truss’s mini-budget in September 2022. However, after Pill’s speech, the pound recovered slightly, strengthening by 0.26% against the dollar and by 0.28% against the euro.

Pill remains concerned about structural changes that could cause inflation to persist longer than expected. Though inflation has dropped from its peak of 11.1% in October 2022 to 2.2%, bringing it close to the Bank’s target, the path forward remains uncertain.

For over two decades, the views of the Bank of England’s chief economist and governor have been closely aligned, providing insight into the Monetary Policy Committee’s (MPC) stance on interest rates. However, the differing perspectives between Pill and Bailey now suggest upcoming MPC decisions could be more hotly debated. In August, the committee narrowly voted to cut borrowing costs by 25 basis points, with Bailey in favour of the cut and Pill preferring to hold rates steady in a 5-4 split. Both agreed to keep rates unchanged in the September meeting, but Pill is not the only hawk on the Committee.

Although the MPC voted overwhelmingly (8-1) to hold rates last month, meeting minutes revealed a variety of views on inflation’s persistence. Some members are concerned about high wage growth and service prices, a point Pill reiterated in his speech, while others see less risk of inflation exceeding the 2% target in the long term.

Following Bailey’s recent comments, financial markets now anticipate the MPC will cut rates by 0.25% at both the November and December meetings, reducing them from the current 5% to 4.5%. Analysts at RBC Capital Markets predict the Bank may continue easing rates through next May.

Economists are closely watching events in the Middle East – in his Guardian interview Bailey also noted that, despite tensions, oil prices have remained relatively stable since the Hamas attack on Israel a year ago, unlike the significant price spikes seen in previous crises.

“From the point of view of monetary policy, it’s a big help we haven’t had to deal with a big increase in the oil price,” he stressed, although he mentioned the need to “watch it extremely closely.”

He added: “There’s also recognition there’s a point beyond which that control could break down if things got really bad. You have to continuously watch this thing, because it could go wrong.”

Executive briefing; Pill’s speech in summary;

1. Role of Monetary Policy in Building the Future Economy

• Pill emphasised the importance of monetary policy in creating a stable economic environment that fosters long-term investment, innovation, and productivity.
• Stability in inflation and interest rates allows businesses and individuals to make informed decisions on investments like housing, education, and start-ups.

2. Price Stability as a Foundation

• Price stability is essential to maintaining a healthy economy. It supports long-term economic planning and helps avoid the negative effects of inflation, particularly on vulnerable groups such as SMEs and lower-income households.
• Inflation has fallen significantly in recent months from a high of over 11%, bringing the rate close to the Bank’s target of 2%.

3. Recent UK Inflation Trends

• Inflation is expected to stay around 2.5% by the end of the year but should decline again next year.
• Despite this, inflation in services remains stubbornly high, indicating persistent underlying inflation pressures.

4. The Monetary Policy Committee (MPC) Framework

• The MPC uses a clear 2% inflation target and relies on an independent, accountable framework to achieve this goal.
• The framework has proven its value in helping manage inflation while avoiding extreme economic volatility or high unemployment rates, unlike in past decades (e.g., the 1980s and 1990s).

5. Cross-Checking Models

• Pill discussed his method of "cross-checking" various economic models to better inform policy decisions. This involves comparing the Bank’s official forecasts with alternative models like Bayesian Vector Auto-regression (BVAR) and Structural Vector Auto-regression (SVAR).
• These models suggest that risks of persistent inflation might be higher than the Bank's baseline forecast, which could require cautious monetary policy.

6. Monetary Policy Decision in August

• The MPC was split on whether to cut the Bank Rate in August 2024, with a 5-4 vote in favour of a reduction. Pill dissented, advocating for a cautious approach to avoid cutting rates too early.
• Pill expressed concerns that structural changes in the economy might require a more sustained response to inflation.

7. Looking Ahead

• The MPC is balancing three potential scenarios:
  1. Disinflation without further intervention, relying on declining inflation expectations.
  2. Disinflation with continued monetary restriction, ensuring inflation does not rebound.
  3. Structural changes requiring prolonged policy intervention to control inflation.
• Pill’s current outlook aligns most closely with the second scenario but he remains cautious about structural risks that could prolong inflation.

In conclusion, Pill stresses the importance of maintaining a cautious approach to monetary policy, with an emphasis on gradual rate cuts to ensure lasting price stability and avoid destabilizing the economy.