What will it take to shift the Bank from wait-and-see on rates?

Financial markets don’t expect the Bank of England to raise UK interest rates this week. Economists agree. The combination of recent encouraging inflation data, a lack of clarity on the new Chancellor’s tax and spending intentions, and volatile events in the Gulf mean there is no urgency to act. At least not for now.

However, with the global oil price hovering around $100 a barrel, natural gas prices up 50% over the last month, and container rates moving steadily higher, this may be a temporary reprieve. Investors are now pricing in almost two full interest rate increases from the Bank of England by the end of the year as it grapples with the prospect that the 2.7% inflation rate seen in June is as good as it gets.

For a Labour Party that trumpeted six interest rate cuts since it took office as one of its signature achievements – which has always been a suspect claim given the cuts had very little to do with government policy - the new top economic team of John Healey and Andy Burnham may shortly have to change their tune.

The first thing to note is that mortgage, loan, and savings rates offered to households and businesses are already reflecting the rapid change in the economic backdrop. Retail banks are not waiting for the Bank of England to move. Mortgage rates have risen to their highest in a month as the inflationary risks have re-emerged. The cost for the UK government to borrow for ten years has also climbed to 5.1% - hovering around levels last seen before the Global Financial Crisis. The world’s largest debtor – the US government – is now paying an interest rate of 4.7% a year for its ten-year borrowing. For investors long starved of yield for investment, these are, nominally at least, an embarrassment of riches. Investors can demand such returns not just because they see high inflation coming, but also because they are seeing strong profits growth in the corporate sector. So governments have to compete for capital.

Back to the Bank of England and, perhaps paradoxically, this response in financial markets makes its job of controlling inflation somewhat easier. Higher interest rates for governments and households restrict their incentive to borrow more and chase prices higher. In central bank parlance these “tighter financial conditions” restrict the growth of money and keep a lid on price growth. Indeed, one of the features of recent months has been the modest growth in the money supply at 4.5% a year. Preceding the price shock of the Ukraine War, UK money supply had been growing at close to twice that pace – helping to fuel the inflation that followed. This is one of several reasons that the Bank of England has not followed its peers at the European Central Bank, Bank of Japan, and the Reserve Bank of Australia in raising interest rates this year.

One major central bank has also followed this path: the US Federal Reserve. Under the new chairmanship of Kevin Warsh, US monetary policymakers have dispensed with forward guidance under which they would provide strong, conditional signals to financial markets on what interest rate policy to expect next. The cynic might suggest this has less to do with an intellectual evaluation of forward guidance as a policy tool - something championed by former Bank of England governor, Mark Carney - but more the unpredictability of the current occupant of the White House. Why pre-commit to a policy path in advance if an unexpected Truth Social post from President Trump can make that look daft in an instant?

So, if we are in a new era of working it out for ourselves then what should we be looking for that could shift the Bank of England from wait-and-see to feeling it must act? Tacking back to the UK economy, I believe there are four things to look out for.

First are inflation expectations. The uncomfortable reality for the Bank of England is that inflation has averaged 3% since 2010. The UK price level is now 20% higher than it would have been had a 2% inflation rate been achieved every year since that target was introduced in 2004. There is a significant risk - indeed increasing evidence - that businesses and households are coming to expect a high level of inflation. This means the credibility of price stability gets lost. Upcoming surveys of how Britons are reacting to inflation arising from the conflict in the Gulf will be key for policymakers at the Bank.

Second is the role of international events. It is inevitable that events in the Gulf will frame both this week’s Monetary Policy Report from the Bank of England, and their policy stance. Interest rate expectations have closely followed oil and gas price volatility. If conflict-related disruption to shipping persists into the autumn, delaying the rebuilding of energy stockpiles ahead of the Northern Hemisphere winter, fuel prices are likely to remain elevated. Expect plenty of soundbites this week from the Bank talking about “standing ready” to act - a well-worn phrase that captures the inherent uncertainty.

Third is the impact of upcoming pay settlements. Private sector pay is running at a six-year low of 2.9% and with unemployment and vacancies data showing a soft labour market there is relatively little evidence that workers will be able to negotiate inflation-busting pay deals. That said there is uncertainty about whether this will hold, particularly in the public sector, given the government has revealed its hand by responding to industrial action and pushing public sector pay inflation up to 5.5% a year.

Fourth and finally is the Autumn UK Budget. There remains a high level of uncertainty on how significant a change of fiscal policy the new Cabinet will attempt. There is an obvious contradiction that the new Labour leadership talk about the biggest economic change in forty years, but everyone in markets knows they are hemmed in by their fiscal rules, the Parliamentary Labour Party, and their commitments in the 2024 manifesto. Resolving that contradiction will have implications for inflation given the role of public policy in explicitly setting prices across many sectors.

Together, these data give the Bank of England a bit more time before changing policy – in either direction. That policy stability - at least for now - is good news for a UK economy that has had too much volatility to contend with in recent years.