Will the MPC follow the global trend and cut interest rates? - Capital Economics
UK Economics

Will the MPC follow the global trend and cut interest rates?

UK Economics Update
Written by Ruth Gregory

There has been mounting speculation that the Monetary Policy Committee (MPC) will join the global loosening cycle by cutting interest rates. We think it will if there is a no deal Brexit. But if there’s a Brexit deal or many more delays, the UK could buck the global trend and raise interest rates.

  • There has been mounting speculation that the Monetary Policy Committee (MPC) will join the global loosening cycle by cutting interest rates. We think it will if there is a no deal Brexit. But if there’s a Brexit deal or many more delays, the UK could buck the global trend and raise interest rates.
  • The global monetary policy cycle has turned. Last week, the ECB geared up for a rate cut in September. Later today, the US Fed looks set to lower rates by 25bps. And central banks in Australia, New Zealand, India, Philippines, Malaysia, Indonesia, Korea and Sri Lanka have already cut interest rates.
  • It is normal for the UK to follow the global trend – especially the US. (See Chart 1.) If it doesn’t, that would prompt sterling to rise, weakening inflation, so the MPC may need to cut anyway. Granted, no one expects the MPC to cut rates from 0.75% at its meeting on Thursday. (See here.) But the markets are now pricing in a 25bps rate cut in the UK by January 2020 as well as a 40% chance of a further 0.25% cut by mid-2020. If there is a no deal Brexit, we think that rates would be cut, from 0.75% to at least 0.25%. But there are four reasons why we think the MPC is more likely to raise rates if there is a Brexit deal or more delays.
  • First, economic conditions in the UK do not appear to warrant lower rates. Admittedly, GDP growth probably slowed to 1.4% in Q2, but that is not far below the UK’s potential growth rate. At 2.0% in June, CPI inflation is exactly where the MPC wants it to be. At 3.8%, the unemployment rate is close to its natural rate of about 4%. And inflation expectations have been rising, not falling like elsewhere.
  • Second, at 0.75%, monetary policy is already loose. Interest rates are well below the Bank of England’s estimate of the long-run neutral rate of 2.5%. Admittedly, Brexit uncertainty has reduced the short-run neutral rate, so monetary policy is not nearly as accommodative as this suggests. But if there is a Brexit deal, a reduction in uncertainty and a probable loosening in fiscal policy should push the neutral rate back up towards its long-run rate. As such, rates should rise just to prevent monetary policy from becoming more expansionary. As Governor Carney put it, the MPC will need to “walk to stand still”.
  • Third, the current monetary policy stance looks much more accommodative in the UK than in the US. As Bank of England Chief Economist, Andy Haldane, recently suggested, the “very different starting positions of the economy and monetary policy should give us cause to pause before simply assuming central banks should be moving synchronously”. While the inflation and labour market performance has been very similar in both the UK and the US, the real interest rate is now about 2ppts lower in the UK. After all, rates in the US have been raised by 2.25ppts since the crisis, while UK rates have risen by 0.5ppts. (See Chart 2.)
  • Fourth, the prospect of a period of fiscal loosening may require tighter monetary policy in the UK. Based on Boris Johnson’s recent pledges, fiscal loosening could be equivalent to about 1% of GDP per annum, in contrast with the broadly neutral stance of fiscal policy expected in the US in the next five years.
  • Overall, in a no deal Brexit we think the MPC would cut rates. If there is a deal or many delays, we would not rule out the UK going it alone in raising rates. However, even if we’re wrong, rates are more likely to be kept on hold rather than cut. This is a key reason why we expect the pound to strengthen to $1.35/£ and to $1.40/£ by end-2021 respectively in our repeated delay and deal scenarios.

Chart 1: UK Bank Rate & US Fed Funds Rate (%)

Chart 2: Difference between UK & US (Jun. 2019, ppts)

Sources: Refinitiv, Capital Economics

Sources: Refinitiv, Capital Economics


Ruth Gregory, Senior UK Economist, +44 20 7811 3913, ruth.gregory@capitaleconomics.com