Bank of England preview

Bank of England preview: setting policy in the era of Trump

This Bank of England is due to cut interest rates for the first time since November on Thursday. Interest rates are expected to be cut by 25bps to 4.5% from 4.75%. This move is widely expected, and we do not expect a shock decision from the BOE. This meeting will also include the BOE’s latest forecasts for growth and inflation, and the BOE Governor’s press conference.

The market is fully priced for a rate cut from the BOE, with a 98% chance of a cut currently priced in by the GBP overnight index swaps market. What the BOE’s updated forecasts tell us will determine if the OIS market is right to expect a further 2 cuts later this year, or if the market is underpricing the prospect of further cuts from the BOE.

Growth downgrades expected, while the long-term inflation forecast is also expected lower

The backdrop to this report is underwhelming. UK growth has weakened in recent months and the outlook looks poor. The OBR is expected to slash its growth forecasts next month, which will be included in the Chancellor’s spring statement. The Bank of England is likely to do the same this Thursday. The BOE had expected GDP to expand by 1.5% this year, that looks lofty after a spate of weak economic data, and it could be revised down to 1%. The risk is that growth could undershoot downwardly revised forecasts, as the Citi economic surprise index is close to its lowest level for a year, as you can see below. This suggests that UK economic data has surprised to the downside by a wide margin.

The case is mounting for the BOE to signal that the market is too cautious about future rate cuts. The BOE already said in December that it did not expect any growth in Q4 2024, while inflation is expected to be revised higher for this year, due to higher energy prices and a weaker pound. However, stagflation fears could be short lived, as we expect the downturn in the economy to weigh on the BOE’s medium term inflation forecast, which is more important for growth. The BOE could forecast that inflation will fall to 2% in the 2-year horizon, and then to 1.6%, below target, in the longer-term horizon. If the BOE does revise down its inflation numbers, then it would open the door to a more aggressive easing cycle.

UK Gilts could get a boost from the BOE

The BOE’s forecasts will be impacted by bond yields, which have been extremely volatile since their last meeting in December. In January, the 10-year Gilt yield rose to 4.88%, the highest level since 2008. Although yields have since fallen by 44 bps, financial conditions in the UK are tight, and this is also weighing on growth. Will the BOE want to see bond yields fall faster, to prevent inflation undershooting its target? We think that some MPC members will have banged this drum at this month’s meeting, including the most dovish members Swati Dhingra, Alan Taylor and Dave Ramsden.

Labour market data a key feature for this meeting

The labour market will also feature heavily in this meeting. There is a clear softening in the labour market. The unemployment rate rose to 4.4% in the three months to November, there was also a sharp decline in payrolls in December, with a drop of 47k payrolled employees. The BOE had expected the unemployment rate to remain stable for 2025, however, if they revise up their unemployment rate forecasts this could be seen as another green light that interest rates will be cut at a more rapid pace this year.

While wage growth was stronger than the BOE’s forecasts for the 3 months to November, the decline in  service price CPI in December, could ease fears about any residual inflationary effects from wage growth. Added to this, there is a lot of uncertainty about the UK labour market. Firstly, the ONS has said that the data is unreliable, and secondly, the Chancellor is expected to announce vast changes to the benefits system, with eh hope that it gets more people off benefits and back into the labour force. Of course, there is a high degree of uncertainty that any change to the welfare budget will boost the number of people in the UK looking for a job, but if it did, this could also weigh on wage growth down the line. Thus, the BOE may note that slack is developing in the UK economy, and this could keep inflation in check down the line.

While we doubt that the BOE will remove its guidance that rate cuts will be gradual, we think that this will be to appease the hawks on the Committee, including Catharine Mann, Megan Greene and Huw Pill. There is a clear basis for a faster pace of rate cuts, but an external factor could mean that the BOE is cautious with its forward guidance at this meeting.

The Donald Trump effect

BOE Governor Andrew Bailey, will not be able to avoid questions about the impact of Donald Trump’s economic policies and his trade policies. Although the UK is expected to avoid the worst of his tariffs, weaker global growth and the prospect of higher global inflation triggered not only by tariffs but also by a stronger dollar, could add to the weaknesses already afflicting the UK economy.

While the Governor is unlikely to spend too long talking about the impact of US tariffs on the global economy, it will be interesting to see if they fed into the BOE’s forecasting models for GDP and inflation. Since inflation is already set to remain above the BOE’s target for the rest of this year, the risks from Trump’s trade wars are real. However, it’s worth noting that the inflationary impact from tariffs are not all to the upside. For example, retaliatory tariffs from China on US energy products, has seen shipments get diverted from Asia to Europe, which is why oil and energy prices have been under downside pressure this week.

The neutral rate

If the market does price in a further rate cut for 2025, this could see interest rates end the year at 3.75%, which is likely to be close to the neutral rate. We think it is too early for Bailey to confirm exactly what is the neutral rate for the UK, however, with inflation still above target in the UK, there will be a limit to how far the BOE can cut rates, even if the BOE errs on the dovish side on Thursday.

The FX view

The pound has gone from hero to zero in 2025, and it is the weakest performer in the G10 FX space so far this year. GBP/USD has recovered in recent weeks, as the strong dollar trade gets pared back as Donald Trump deescalated his tariff threats to Mexico and Canada. As we lead up to this meeting, GBP/USD is above $1.25. The pound has also clawed back some losses as UK bond yields have stabilized in recent weeks. While lower bond yields usually weigh on a currency, this is not the case for the pound since it also lowers the political risk premium.

While it may be difficult to sustain life above $1.25 for GBP/USD if the BOE does signal that there could be a fourth rate cut this year, the market is already expecting just under 3.5 cuts this year, so there is only a limited amount of cuts left to price in by the OIS market, which may support the pound. Downside levels to watch include $1.24, and if there is a larger dovish surprise than expected, we could see GBP/USD fall below $1.23. We think this is unlikely, since lower rates could also brighten the UK’s dismal growth outlook, and GBP/USD has an inverse correlation with the 10-year Gilt yield, as you can see below.

EUR/ GBP is a cleaner play on the BOE meeting, since the dollar impact is somewhat neutralized. This pair remains weak, however, there are reports that some EUR/GBP shorts have been cut around the £0.8320 level, in case there is a dovish surprise from the BOE. £0.8450 remains medium term resistance.

Chart 1: Citi UK economic surprise index, it is at its lowest level for a year, as economic data continues to surprise to the downside.

Source: XTB and Bloomberg

Chart 2: UK 10-year bond yields and GBP/USD

Source: XTB and Bloomberg