Trade war fears strengthen the case for faster interest rate cuts

This commentary risks presenting this week’s deliberations by the Bank of England as straightforward. They are nothing of the sort. There is plenty of uncertainty around how the UK economy evolves from here. How the MPC interprets the latest economic crosscurrents will have a material impact on the price of mortgages, loan and credit card debt - as well as savings rates and asset prices - over the summer months. Whilst there is little serious debate on the Committee whether interest rates need to be as high as they were after inflation peaked at more than 11% in late 2022, the deliberations on the Committee will be over what level, and how fast, they should reach a more stable balance. That balance, known as the equilibrium interest rate, is heavily contested. Estimates for the equilibrium interest rate are central to pricing a whole range of financial products and assets across the UK economy.

The largest uncertainty that has emerged since the MPC met seven weeks ago - a meeting at which they left Bank Rate unchanged - is the impact of President Trump’s Liberation Day tariffs. Whilst the short term impact has been a whipsawing in global bond and share prices - not to mention the price of Gold and crypto assets – the Bank’s job is to evaluate the longer term impact. Their role in the UK economy is to set an appropriate cost of money for two years from now. That is a tricky job when the US President doesn’t appear to have a coherent plan for two days from now.

To the credit of Bank policymakers they have not been silent in recent weeks – a tempting approach amidst such radical uncertainty. Deputy Governor, Clare Lombardelli has noted clear downside risks to UK growth from international trade conflicts. External MPC member Megan Greene has suggested US tariffs are more of a disinflationary risk than an inflationary one for the UK economy. Greene cites the fact that heavily-tariffed goods destined for the US economy may be diverted into European economies. This would put downward pressure on UK consumer prices.

Whilst the views of Lombardelli and Greene lend themselves to further and faster UK rate cuts, they are far from consensus. Retaliatory actions by the UK to both US tariffs, and to product dumping from other countries - most notably China - could be inflationary. Whilst retailers have largely welcomed the government’s recently-announced review into the tax exemption currently enjoyed on low-value imports - an exemption that favours the likes of Temu and Shein - there is little doubt that establishing a tax level playing field will put upward pressure on UK prices.

Also it is far from clear that consumers and businesses have concluded that price growth will slow in response to the US-led tariff war. Recent household surveys suggest that inflation expectations remain uncomfortably high as the impact of utility bill increases and National Insurance hikes work their way through the economic system. Central banks are rightly nervous about inflation expectations getting embedded in the mindset of consumers and businesses. These surveys will trigger a cautiousness over going too far, too fast.

Having said that the most powerful and durable impact of Liberation Day has been how it has triggered lower energy prices and shipping container rates, as well as strength in non-Dollar currencies - including the Pound. These changes will bear down on inflation over any meaningful time horizon. For household budgets looking for some light relief, forecourt petrol prices have recently hit a four-year low at 134p per litre. These prices look set to fall further amidst softening global demand for oil. The Energy Price Cap paid for by most UK households is set to fall by 9% from July according to energy consultants, Cornwall Insights. There are further reductions forecast heading into next winter. A stronger Pound will also mute some of the imported food inflation that supermarkets have been warning about. It is these numbers that have led financial markets to conclude that a faster pace of interest rate cuts is coming, not just in the UK but across all major developed economies. For a UK consumer whose spending is heavily-influenced by energy costs and interest rates this starts to look like a rather more favourable summer than had been feared.

A couple of miles West of the Bank of England’s City base, in Westminster, these developments are not going unnoticed. Hit by stinging local election results the Labour government is desperate for a better cost-of-living story to tell. Lower price growth and lower interest rates will be lauded as signs that the stability part of the Chancellor’s growth plan is working. To link the two is something of a stretch. The UK economy is just 3% of the global economy, so the UK’s economic weather is largely made offshore. Despite this sobering fact, successful economic policy require luck as much as judgement. For an embattled Chancellor, her luck may just be on the turn.

Given this is an opinion column my own view is that the case for a faster pace of UK rate cuts has strengthened in recent weeks. I began the year believing the Bank of England would cut their interest rate faster than financial markets were expecting, and that pathway seems to be widening. For me, the case - notwithstanding international events - hinges on the fact that elevated UK wage inflation at almost 6% a year is not a function of a lack of workers, post-pandemic demand, or a spillover from workers trying to match their wages to rising prices. Residual wage inflation is almost all the result of regulated pay - largely from above-inflation increases in the National Living Wage. This suggests to me that demand conditions - framed by interest rates - are having very little impact on inflation. The cost of credit can therefore be loosened and encourage consumers to spend a little more, and save a little less. In doing so the UK could well avoid some of the most damaging side effects of the trade war without further inflaming inflation.

This week the Bank gets to reveal its own thinking. The UK economy will be watching.