Interest rates to fall to 3.5 per cent City firm predicts
The Bank of England will cut interest rates to 3.5 per cent by early 2026, analysts at Capital Economics said, despite signs that inflation will rise to nearly twice the two per cent target.
Paul Dales, chief UK economist at the City consultancy, said it was “very unusual” for the Bank of England to cut interest rates when inflation is expected to rise further even further above target.
Inflation currently stands at 3.0 per cent, and the Bank of England predicts that the headline rate will hit 3.7 per cent later this year due to rises in food and energy prices.
And yet policymakers have signalled that they will continue to gradually and carefully cut interest rates, with markets anticipating two further rate reductions this year.
“The big question is whether, as was the case in 2021/22, the Bank is again caught out by inflation rising further than it forecasts and/or being higher for longer,” Dales said.
He argued that the Bank’s gradual approach rests on two crucial judgements.
First, policymakers assume that April’s increase to employers’ national insurance will not boost inflation significantly, because firms will find it challenging to pass on higher prices to consumers.
Secondly, rate-setters think that the labour market is much looser than in 2021, which will stop workers demanding much bigger pay packets to compensate for higher food and energy prices.
Although Dales acknowledged that there were some upside risks, he predicted that inflation would return to target thanks to a “significant” slowdown in wage growth.
“Sustained rises in inflation are almost always driven by the demand for labour outstripping the supply of labour, and the best barometer of that is the job vacancy rate.”
“This suggests that, unless there has been major structural changes in the labour market, it is only a matter of time before average earnings growth slows from six per cent to rates more consistent with the inflation target,” he said.
He said the job vacancy rate is consistent with wage growth falling to 2.0 per cent.
Dales expects the Bank of England to reduce borrowing costs three more times this year, with two further cuts in early 2026, bringing the Bank Rate to 3.5 per cent.
This is a more dovish assumption than market pricing, which assumes the benchmark interest rate will only fall to 4.0 per cent.