Interest rate cuts are entering the countdown! How should the Bank of England respond to rising inflation expectations and high wages?

Despite consumer price inflation reaching close to twice the Bank of England's 2% target in June, the market widely expects the Bank of England to cut the benchmark interest rate from 4.25% to 4% on Thursday, and to cut rates again before the end of the year. However, there is a disagreement among policymakers about the extent of potential easing of price pressures, and whether a failure to further cut interest rates would lead to inflation falling below the target level in the medium term. The following chart shows some of the topics that policymakers may discuss before the decision on Thursday. Global Background and Outlook After the Russia-Ukraine conflict in 2022, inflation in the UK soared higher than in the Eurozone and the US, peaking at 11.1%, partly due to its high dependence on natural gas for heating and power generation. Inflation dropped significantly in 2023, hitting a low of 1.7% in September 2024, but rebounded more strongly than in the US and Europe thereafter. The Bank of England forecast in May that inflation would not return to target until at least early 2027. In June, the inflation rate rose to 3.6% (the highest since January 2024), with some economists predicting it would soon exceed 4%. In comparison, the European Central Bank expects Eurozone inflation to remain slightly below 2%. Increasing Inflation Expectations Most Bank of England officials view surveys of business and household inflation expectations as important indicators of future price trends, wage demands, and the credibility of the central bank. These indicators have been climbing over the past year: the Citigroup/YouGov long-term inflation expectations index has reached its highest level since the end of 2022 (when overall inflation hit double digits), and the Bank of England's own survey has also reached a new high since 2019. However, some officials believe these surveys reflect reactions to recent inflation rather than forecasts of future behavior. Significant Domestic Inflation Stickiness Despite a significant rebound in overall inflation after a sharp drop in 2023, two key indicators of long-term domestic price pressures have remained high: inflation in the service sector, significantly affected by labor costs, and core CPI excluding volatile factors, have both been consistently higher than overall inflation. Additionally, food and beverage prices, which have a significant impact on public perception of inflation (especially for low-income groups), are rising at an accelerating pace. Wage Growth Slows but Remains High The annualized regular wage growth in the private sector has dropped from a peak of over 8% two years ago to slightly below 5%, but remains about 2 percentage points higher than pre-pandemic levels, significantly above the 3% benchmark that policymakers consider to be in line with the 2% inflation target. The Bank of England and surveyed employers both expect wage growth to further slow to 3% over the next 18 months, but the decline over the past year has not been smooth, and an increase in unemployment and a decrease in job vacancies may not necessarily ensure that wages cool rapidly as expected. PMI Shows Rising Cost Pressures The S&P Global Purchasing Managers' Index for July shows that UK businesses are "strongly" raising prices. Although the increase has decreased compared to 2022, the survey shows that current price increases are still higher than pre-pandemic levels. Costs have significantly risen in the service and manufacturing sectors over the past year, and if passed on to consumers, they will push up prices.