So how realistic is the May rate cut? We believe that for this to happen, three things may need to happen.
The first is that services inflation needs to show more progress and, in the short term, we believe it will remain stuck between 6% and 7%. The March figure, which will be the last reading available before the May meeting, will likely be only slightly lower. Wage growth, which is the other key metric the Bank of England has its eye on, should show a little more progress, but surveys suggest it is also likely to be quite gradual in the short term. Better news on both services inflation and wage growth should follow in the second quarter. But we believe it would take a series of additional downside surprises to convince the Bank to make imminent cuts, something it currently seems very reluctant to do.
The second thing to look out for is the government’s spring budget in March. we wrote last week We believe the recent fall in market rates will give the government approximately £12 billion extra to spend while still complying with its key fiscal rules. This adds to the £13bn “headroom” left over from November’s Autumn Statement and, in total, gifts the government up to 1% of GDP in fiscal stimulus to play with if it so chooses.
A big fiscal boost in March could well be cited as a reason for the Bank of England to wait until the summer before cutting rates.
The government is widely expected to spend at least some of that amount in the March budget, and media reports suggest that an income tax cut is a likely candidate for that stimulus. The question is how big the fiscal injection is at the moment and whether the government intends to split it in two with another budget closer to the long-awaited autumn elections. Sunday weather recently reported that the government was considering holding a second budget event just before the campaign begins.
This detail potentially matters for the Bank of England, which bases its interest rate decisions on whatever government policy is officially in place at the time. A big fiscal boost in March could well be cited as a reason for the Bank of England to wait until the summer before cutting rates. This is a key factor in our call for rate cuts to begin in August. But a more moderate fiscal package could keep a May cut in play.