Market News

By Philip Aldrick

(Bloomberg) -- The Bank of England can cut borrowing costs five more times to 3.5% before it runs the risk of overheating the economy and reigniting inflation, according to Bloomberg Economics.

Estimates by Chief UK economist Dan Hanson suggest the so-called neutral interest rate is between 3% and 4%, higher than previously thought. He assumes the mid-point — 1.25 percentage points below the current level — will be where rates settle.

Gauging where monetary policy neither restrains nor stimulates growth is increasingly key for policymakers as they seek to deliver a soft landing from the inflation shock of 2022 and 2023. The BOE is reversing policy after the most aggressive rate-hiking cycle in decades to tackle inflation that briefly topped 11%.

BOE Governor Andrew Bailey last week indicated that four quarter-point cuts over 2025 was likely, taking the benchmark to 3.75% from 4.75%. However, he has refused to be drawn on the neutral rate other than to say it will be higher than the near-zero level of rates of 2009 to 2021.

“The space for going much further without fanning inflation looks limited,” Hanson said. He expects the BOE to deliver one further cut in 2026, stopping well short of the 3% he previously expected. 

As central banks continue cutting rates next year the “debate about the end point for the monetary policy easing cycle is likely to intensify,” Hanson said. 

Both the European Central Bank and the US Federal Reserve have modelled neutral scenarios but the BOE has not revisited the topic since 2018 - when it estimated the neutral rate to be 2%-3%.  

Deputy Governor Clare Lombardelli said last month that the neutral rate was “unobservable” and that “it wouldn’t really be sensible for us to try” to estimate it. Former rate-setter Gertjan Vlieghe responded by accusing the BOE of suppressing debate about the issue, saying officials “need to take a view” on when to stop cutting rates.

Swati Dhingra, the most dovish member of the Monetary Policy Committee, last week told Bloomberg TV she believed the neutral rate had “risen to some degree” and is now between 2.5% and 3.5%. Catherine Mann, the most hawkish member, believes the rate has increased, meaning current policy settings are not as restrictive as assumed. 

Earlier this year, Charles Goodhart, a founding member of the MPC, said the long-term neutral rate might be a little above 4%.

Hanson used a methodology similar to one outlined by the US Federal Reserve, which reflected the UK’s surprising resilience to the sharp increase in rates to 5.25% from 0.1% over just 20 months. 

One of the “key observations” from the experience of the 2022 and 2023 rate-rising cycle was “that the economy has held up better than most models would suggest,” he said.

“Around half the rise in the BOE’s policy rate appears to have been matched by an increase in the neutral rate. If that’s right, it explains much of the economy’s resilience to higher rates. It also has big implications for where borrowing costs will settle.”