Why I can see UK interest rates below 3% next year
The Bank of England spent the week being wrong – on wages, on prices, on growth, and all in the same direction. Follow the data instead and you arrive somewhere the MPC won't go: inflation below 2%, rates below 3%. A cat amongst the pigeons, in other words.
First published in Noise Cancelling
Last week in Truth is ever to be found in simplicity; amongst other things, I highlighted Ben Bernanke’s criticisms of the Bank of England’s UK economic model. Its complexity, rigidities and out-of-date infrastructure have handicapped it and the institution that relies on it to accurately forecast what’s going on in the UK economy. That, combined with what I believe are serious judgement errors among the more academically minded members of the MPC, has, at best, undermined its credibility and, at worst, led to explicit monetary policy errors.
Some might think this criticism is unwarranted, given that forecasting is a tough gig, but my argument is that this organisation has significant competitive advantages in the forecasting game, given the resources and data at its disposal, and so, quite simply, it should be better at it.
At the risk of boring my audience with this favourite hobby horse of mine, less than a week after writing about this subject, I was once again reminded of this very real problem following the release of two important sets of UK data: one on the labour market and the other on inflation.
Once again, this new information has shone an even brighter light not just on the forecasting and judgement errors of the rate-setting committee but, perhaps more seriously, on the consistent directional errors – or, for those statistically minded readers, Type III errors.
Second round effects, still missing
Earlier this week the ONS released another set of labour market data. Reflecting many of the labour market pressures I have been writing about for nearly two years, payrolled employment fell in the three months to the end of May and was 0.3% lower than in May last year. Unemployment was steady at 4.9%. So far so relatively uncontroversial.
My issue is with the wage growth numbers. Remember, this is probably the most important issue the hawks on the committee have been most concerned about (so-called second-round effects of the energy price shock) and was what persuaded two of them to vote for higher rates at the last meeting.
In summary, their view is that an energy price shock is followed by second-round effects that embed inflation in the economy and must be headed off by higher interest rates. Chief amongst these effects are inflationary wage increases demanded by workers whose disposable incomes have been eroded by higher energy costs.
Whilst the Bank of England’s chief economist Huw Pill and Megan Greene were persuaded that so dangerous were these effects that they required a pre-emptive rate increase to head them off (the market was at one time expecting up to four of them), I have been arguing that these concerns were misplaced and, given the underlying situation in the labour market, namely increased unemployment and rapidly falling vacancies, these second round effects would not materialise and that the MPC and the market were both wrong about this issue.
I highlighted the evidence supporting this view in the wage settlement data, which showed a consistent decline that began in the middle of 2023 and accelerated at the start of last year. In the latest ONS data release earlier this week, that evidence was underlined by a further fall in whole economy earnings growth to 4.3% (it was 4.9% in the same month last year) and, more significantly, private sector pay growth, which in May fell even further to 2.7%, the lowest level in nearly six years.
The wage spiral that never came
The inflation miss
The second ONS data release was today’s inflation report. Remember that the backdrop here is that the MPC has been warning about the potential inflationary consequences of the war (its three scenarios published at the end of April were wildly too pessimistic) and, in particular, hawks on the committee have been consistently highlighting the worrying consequences of second-round effects.
In the Bank of England’s April Monetary Policy Report, published on 30 April, the forecast for June’s CPI was 3.1%. Today the outturn was 2.6%, a full 0.5% below its forecast. Core CPI was unchanged at 2.6%. Food price inflation fell further in June to 1.6%, and clothing prices actually fell year on year.
Once again, the Bank of England’s forecasts were wrong but, perhaps most worryingly, were directionally wrong. Inflation has fallen, not risen, since April, despite the war, as it has done in 2026 as a whole (December’s CPI was 3.4%).
Wrong on growth too
So, the MPC has been too negative on second-round effects, has misread the labour market and significantly overestimated inflation. But what about growth? Well, not surprisingly, the Bank has got this wrong again by being too bearish.
The ONS GDP data showed growth of 0.6% in Q1; the Bank has subsequently said it thinks this is an overestimate and that “underlying” growth was only 0.2%. Since when the data has, once again, been better than expected. It now looks like Q2 will see growth of about 0.4%, but the Bank forecast in April that Q2 growth would be only 0.1%.
In other words, whilst the Bank was expecting the economy to deliver something like 0.3% growth in the first half of the year, the outturn looks to be close to 1%.
What it adds up to
This forecasting omnishambles is even more worrying when each element is combined and compared with an overall picture of what’s actually happening in the UK economy.
Whilst the Bank thinks that the economy is only growing by 0.3% in the first half of 2026 but that stresses in the labour market will result in higher wage settlements and higher inflation, the reality is that the economy is growing much faster, wage settlements have continued to ease (no evidence of second-round effects) and inflation has fallen to well below the Bank’s expectation.
Quite how Huw and Megan can continue to call for higher rates is beyond me. Both have been clean bowled by the data, and I suspect July’s Monetary Policy Report will contain both a growth upgrade and an inflation downgrade.
The second half of the year will inevitably see some kind of pick-up in inflation as higher pump prices work their way into the headline numbers, and I would be surprised if growth was as good in H2 as it appears to have been in H1, but the starting point in terms of better growth and lower inflation is so much better than the Bank or consensus has been forecasting.
As I think about what’s in store for next year, I am becoming more confident in a better growth outcome given that the rate of household saving appears to be declining, and my guess is that inflation outcomes will be significantly better.
If the war finally comes to an end and energy market “normality” returns, I can see UK inflation in the second half of next year falling below 2%, which I believe would be consistent with interest rates below 3%.
Now that really would set the cat amongst the pigeons!
Important information
The views expressed in this article are those of the author at the date of publication and not necessarily those of Curated Capital Ltd. The contents of this article are not intended as investment advice and will not be updated after publication unless otherwise stated.