The Bank of England has eased the brakes. What happens next?

I was fortunate to watch Tom Pidcock clinch mountain-bike gold live for Great Britain. It reminds me of the sharp daily descent I make to the cycle park underneath Legal & General’s One Coleman Street offices. You have to grip the brakes tightly while turning a corner to stay safe.

The Bank of England finally started to ease its ‘restrictive’ grip on the UK economy on Thursday last week, but it was a close decision: 5 voted to cut, 4 to hold, and some of those voting to loosen policy said that the decision was ‘finely balanced’. That tone of voice suggested a September rate cut was less likely, but in the days that followed, weaker jobs data in the US has pulled risk assets sharply lower and, in our view, made rate cuts by central banks around the world more likely in the coming months.

In last week’s meeting, the Bank of England was keen to present two scenarios. First – on the bright side – although wages and services inflation remain uncomfortably high, they have slowed. With lower energy prices pushing overall inflation back towards target, their ‘modal’ view is that wage and price setting could normalise next spring, helped by a loosening labour market (i.e. lower vacancies and a gradual rise in unemployment).

However, the Bank was also keen to flag upside risks to inflation in an alternative scenario, flagging that there could be longer-lasting changes to price-and-wage setting behaviour. Meanwhile, growth could be stronger or there could be less slack in the labour market than they assume. Monetary policy could also be less restrictive than assumed (the Bank noted that housing data had held up well).

I have sympathy with the concern about ‘upside’ inflation risks. The Bank continues to estimate that the economy is operating at ‘normal’ capacity and slack will open up over the next year. Yet surveys of recruitment difficulties remain at cyclical highs, as the chart below shows.

However, the Bank chose to show a different survey that began during the Covid-19 pandemic. Yes, things have improved since then. But that doesn’t mean things are back to normal.

Similarly, although the Bank played down the April spike in inflation as ‘backwards-looking, indexation effects’; their new measure of underlying services inflation has moved sideways at 5% over the past year.

At face value, the Bank’s inflation forecasts suggest they should ease more aggressively than markets are pricing in: in their modal case, inflation is below target in two and three years’ time, and even in the alternative case, inflation is at target in two years but below it in three years.

Yet the underlying tone suggests that – unlike Tom Pidcock’s rapid descending style – they won’t release the brakes aggressively. Instead, we believe that the Bank will proceed cautiously until it sees the ‘whites-of-the-eyes’ of low wage and services inflation.

In terms of the investor response to the Bank’s first cut since the pandemic, we first saw a modest downward move in yields given that markets had only priced in 2/3 of a chance of a cut beforehand. However, the gilt market remains more driven by weaker US data and in the last few days gilt yields have continued to move lower as a result.

So the TLDR is this. Yes, the UK’s descent from table mountain has begun. But don’t expect Olympian-style descending heroics. A more cautious, economist-style approach to future rate cuts looks more likely to us, unless the market moves to a ‘hard-landing recession’ narrative in light of the broader fall in risk assets in recent days.