Will the Bank of England know when to stop?

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Opinion

As we approach the one-year mark of interest rate cuts, the future remains uncertain. The pace of rate cuts in the G20 countries has been unprecedented, with a quarter of monetary policy meetings resulting in a cut in the first three months of the year. However, when compared to the high interest rates and inflation levels seen before the 2008 financial crisis, the current rates are still relatively high.

The Bank of England has emphasized that interest rates are not on a predetermined path and are unlikely to return to pre-pandemic lows. The decision on how far to cut rates remains unclear, as policymakers navigate through unprecedented challenges like energy shocks, pandemics, and tariffs in the era of independent central banks.

Economists analyze interest rates as a combination of a natural rate that maintains equilibrium in the economy and a cyclical component that policymakers adjust to steer the economy in the right direction. The UK’s current base rate of 4.25% still includes a cyclical element that aims to keep inflation in check. The Bank of England’s rate-setters are considering further cuts to cool inflation, which currently stands at 3.5%.

As inflation trends towards the 2% target, the Monetary Policy Committee will continue to cut rates until the cyclical component is eliminated. However, there is disagreement among rate-setters on the speed of these cuts, with some advocating for faster reductions due to temporary inflation drivers and global financial conditions.

Looking ahead, assuming no major shocks, inflationary pressures are expected to ease over the next 18 months, allowing interest rates to gradually return to a long-term equilibrium. However, uncertainties remain, with research suggesting that the post-pandemic equilibrium rate may be higher than previously thought due to factors like government debt issuance, financial fragmentation, and technological advancements.

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In conclusion, the path of interest rates remains uncertain, with market expectations and economic models pointing towards a gradual decline in rates over the next few years. Even with inflation under control, the new normal for interest rates may be higher than pre-crisis levels. The Bank of England and other central banks continue to monitor economic conditions closely to make informed decisions on future rate cuts.

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