The Bank of England cuts interest rates by 25 basis points as scheduled, suggesting that weakening inflation may lead to further easing next year.

The Monetary Policy Committee of the Bank of England decided on Thursday, with a 5:4 vote, to lower the benchmark interest rate by 25 basis points to 3.75%, the lowest level in nearly three years, in line with market expectations. This is the first rate cut by the Bank of England since August, as in the previous two policy meetings, the Bank of England chose to stay put. Bank of England Governor Bailey, after a series of recent data showing a downward trend in UK economic growth, the job market, and price pressures, chose to support a 25 basis point rate cut, a widely anticipated easing measure. At the same time, the Bank of England also suggested that the cooling inflation is sufficient to further ease monetary policy in 2026. The Bank currently expects inflation to be "closer" to its 2% target level in spring next year. The Monetary Policy Committee stated that the current evidence indicates that borrowing costs will continue to decline next year. However, the Monetary Policy Committee warned in its new wording that as policy rates gradually approach the "neutral rate" - a level that neither boosts nor suppresses inflation - the decision on whether to continue lowering rates in the future will become more delicate and difficult to balance. Bailey stated in his remarks, "We still believe that rates will gradually decrease. But as we cut rates each time, how much further we can go in the future will become a more carefully balanced decision." The minutes of the meeting suggest that the Bank of England may be nearing the end of this rate-cutting cycle, and warned that the policy stance is no longer so restrictive, with the extent of monetary policy easing next year depending on the evolution of inflation prospects. As a result of the policy guidance provided by the Bank of England, the pound and the yield on the ten-year UK government bonds erased their previous declines. The yield on the two-year UK government bonds, the most sensitive to interest rates, rose by 3 basis points to 3.47%, while the yield on the ten-year UK government bonds rose by 2 basis points to 4.49%. The pound was relatively stable against the US dollar, trading around 1.3383. At the time of the Bank of England's decision to cut rates, market concerns have gradually shifted from stubborn inflation to weakness in the economy and labor market. The Bank of England warned that GDP growth in the fourth quarter is expected to stagnate, compared to the previous forecast of 0.3%. However, the Bank also added that the fundamental health of the economy has not changed, and there are signs of a rebound in business surveys following the budget announcement. A series of economic data released in the past week and the relatively mild government budget were seen by traders and economists as key factors leading to Thursday's rate decision. Data released by the UK's Office for National Statistics on Tuesday showed that the UK unemployment rate rose to its highest level in nearly five years, while wage growth slowed down. The unemployment rate rose to 5.1% in the three months to October, up 0.1 percentage points from the previous reading, the highest level since early 2021, in line with economists' expectations. Meanwhile, the average wage growth rate excluding bonuses dropped from 4.7% to 4.6%, the lowest level since early 2022. Wage growth in the private sector fell below 4% for the first time since 2020. Although these data were slightly higher than expected, tax data for November showed a reduction of 38,000 employees on payrolls, exceeding expectations. Moreover, data released on Wednesday showed that the Consumer Price Index (CPI) rose by 3.2% year-on-year in November, the lowest level in eight months, lower than the market expectation of 3.5% and the previous value of 3.6%, mainly due to a decline in prices of some food items like cakes, biscuits, and breakfast cereals. It is worth mentioning that the rate decision also exposed serious divisions within the Bank of England's Monetary Policy Committee regarding the outlook for interest rates. All four hawkish rate-setters opposed the rate cut, with Catherine Mann stating that her vote to keep rates unchanged was a "difficult balance," and Megan Greene acknowledged that inflation risks were tilting down. Among the five members who supported the rate cut, three, including Bailey, stated that they would continue to closely monitor wage pressures. Two dovish members - Swati Dhingra and Alan Taylor - emphasized the downward risks facing economic growth and inflation. The Bank of England's easing cycle may be nearing its end While the Bank of England cut rates as expected, policymakers will now face a tricky question - has the loosening cycle, which started less than a year and a half ago, reached its endpoint? Bailey's recent references and other indicators show that the UK's "neutral rate" is within reach, and the current rate is only one or two rate cuts away from that level. Although most members of the Bank of England's Monetary Policy Committee have been reluctant to specify their desired range for the neutral rate, the concept has quietly become an important consideration in decision-making. The key disagreement within the Monetary Policy Committee lies in how to balance the persistently high inflation in the UK with the ongoing weakness in the job market. Since the start of the current easing cycle in August 2024, the interplay between these two forces has made the progress of rate cuts increasingly challenging, and as the policy rate nears the neutral level, future rate cut operations will be more challenging. While the Bank of England suggests downward risks to inflation, the inflation outlook in the UK still faces challenges. The fiscal tightening announced by the Labour Party government in the autumn budget has not alleviated inflation stickiness and may even exacerbate service inflation through cost pass-through. Measures in the budget such as freezing the employer national insurance threshold, tightening pension contribution tax relief, and reducing business depreciation deductions will directly or indirectly increase operating costs for businesses. These cost pressures may be passed on to goods and services prices, especially given that the service sector accounts for over 80% of the UK economy, further raising core inflation. However, UK Chancellor of the Exchequer Rachel Reeves defended her latest budget policy in correspondence with Bailey. She stated that the decision to freeze railway ticket and prescription drug prices, as well as providing a 150 annual energy bill rebate to each household, would reduce the inflation rate by 0.5 percentage points. She further stated, "I know there is more work to be done." Prior to this, Paul Dales, Chief UK Economist at Capital Economics, stated, "From now on, the threshold for each rate cut will be significantly higher. Despite the serious disagreements among members, I can't help but guess that the near 'inertial' pace of rate cuts may come to an end." Economists surveyed expect the Bank of England's benchmark interest rate to fall to 3.25% in the second half of next year. In contrast, investors' expectations are more pessimistic, betting that the eventual benchmark interest rate will stabilize at around 3.4%. This means that if the Bank of England cuts rates this week as expected, policymakers will only have one more 25 basis points of rate cut space, and further cuts may pose a risk of stimulating inflation rebound.