Could the Bank of England beat the Federal Reserve and cut interest rates first?

By the end of 2023, the US Federal Reserve was in a prime position to begin cutting interest rates. In the space of four months that narrative has been turned upside down.

Chairman Jerome Powell has been forced to rule out rate cuts in the coming months amid disappointing economic data.

At the same time, economic indicators from the eurozone and the UK suggest there is room to start cutting rates in the summer.

It has pushed markets to consider whether we might start to see a significant divergence between the Federal Reserve and other central banks.

Could the Bank of England break with tradition and ease monetary policy before the Federal Reserve? Or will UK households have to wait a little longer for the base rate to be reduced?

When will the Federal Reserve cut rates?

Late last year, markets assumed there would be around seven US rate cuts in 2024.

But successive data on inflation, payroll and retail sales hampered the process, and Powell now says it would “take longer than expected.”

Inflation is too high for the central bank’s liking and remained stubbornly above 3 percent at the last reading. The Federal Reserve’s target rate is 2 percent.

The headline rate hit 3 percent last June, its lowest rate since early 2021, but has fluctuated between 2 and 4 percent since then.

The surprise rise in inflation in February and March dashed investors’ hopes of possible interest rate cuts by the summer.

Markets are not pricing in a rate cut at the June meeting, although they remain in play for later this year, probably in the fall.

“We have changed our expectation (from October) that the Federal Reserve will begin easing monetary policy in June, and now look to September,” says David Page, head of macroeconomic research at AXA IM. “We now expect only two cuts this year and forward rates have risen significantly.”

ING economists also forecast the first move in September, before further cuts in November and December.

Does the Bank of England have to follow the Federal Reserve?

With persistent US inflation ruling out imminent rate cuts, attention has turned to what the UK central bank might do.

The latest reading of UK inflation fell from 3.4 per cent to 3.2 per cent between February and March. Core inflation also fell, although not as much as the headline rate, to 4.2 percent.

However, expectations for rate cuts have eased in recent months as US inflation rises.

There is a risk that, while the CPI has fallen, the UK could well follow the US with inflation remaining at the 3 per cent mark.

While headline inflation is expected to fall, the Bank needs service sector inflation and core inflation to also decline.

ING economists say: ‘The Bank of England’s pricing has seen expectations rise more in line with the US narrative. Certainly, tighter-than-expected inflation data and even stronger wage growth have contributed to that sentiment.

While Capital Economics says: “We believe that the legacy of a weaker British economy will mean that inflation in the UK will fall more than in the US and that this may be one of those rare occasions when the Bank of “England cuts interest rates sooner and sooner.” than the Federal Reserve.’

The Bank of England has generally followed US rate cuts, largely due to sensitivity to monetary weakness.

The Federal Reserve has ruled out imminent rate cuts as inflation continues to rise

Of the eight cut cycles since 1980, rates have been cut first in the UK only once, says Capital Economics.

But it’s not a hard and fast rule. ING economists say the link between Federal Reserve and Bank of England policy is often exaggerated.

“There are many examples where the Bank of England has distanced itself from the Federal Reserve in significant ways, with the 2016-2018 US rate hike cycle being the most recent,” they say.

‘Those concerns about the impact of a weaker currency have probably taken a backseat.

‘Not only is inflation much lower and there is greater confidence in the coming disinflation, but sterling has been one of the most resilient G10 currencies in the face of renewed dollar strength. In a sense, that offers a bit of protection against any new weakness and transmission to inflation.

“We don’t think the Bank of England will have many qualms about cutting rates with the Federal Reserve, or about moving a little faster at subsequent meetings.”

Ruth Gregory, deputy chief economist at Capital Economics in the UK, believes the central bank could be worried about “the potential inflationary effect of a weaker pound if it cuts interest rates first and further”, especially if second-hand effects round on inflation raises expectations and salaries. .

However, he predicts that the chances of second-round effects are likely to be lower.

‘We think UK inflation will be lower than US inflation and domestic prices will have less momentum. That may mean the Bank cuts interest rates earlier and more deeply than the Fed… the big and obvious risk is that UK inflation trends follow US trends.’

When will the Bank of England cut rates?

The inflation picture in the United Kingdom is currently very different to that in the United States. The headline rate looks likely to fall below 2 percent in the coming months as food and energy, which had previously been important drivers, are falling.

The 12 percent drop in household energy bills in April will drag down this month’s reading, which will likely be followed by a further drop in costs in July.

This will add to market expectations that the Bank of England could start cutting rates as early as June.

ING economists point out that Andrew Bailey has tried to put distance “between domestic monetary policy and that of the Federal Reserve, stating that the dynamics of European inflation were different from that of the United States, where it was more demand-driven.” .

They add: ‘We don’t hear from Bank of England officials as often as we do from their colleagues at the ECB or the Federal Reserve…hence the current chorus of optimism about the inflation outlook among key figures at the Bank of England seems both intentional and significant. ‘

So if the central bank gets ahead of the Fed, when might we start seeing base rate cuts?

Page says “an interest rate cut in June still looks more likely, with two more cuts in September and November.”

“However, the risk would be a delay until August if inflation and wage growth continue to exceed expectations.”

ING economists predict services inflation could be stiffer, tipping the balance in favor of a cut in August rather than June.

‘Whatever happens, it looks like the Bank of England could well cut rates before the Federal Reserve, where we expect the first move to come in September. “We believe the full Bank of England cuts this year will also be larger.”

It could also depend on when the European Central Bank (ECB) starts cutting rates. The mood has been largely positive as economic activity begins to improve, driven primarily by services, although the manufacturing sector remains weak.

The ECB continues to signal a cut in June and markets generally agree that there will be three cuts by the end of the year.

ING economists say: “Clearly, the Bank of England should be between the ECB and the Federal Reserve in terms of timing, and we think it should probably correct further towards August, as the most likely date for a rate cut according to the forecast of our economist”.