Bank of England should not follow the herd on interest rates

Central bankers are herd animals. When their global counterparts are on the move, they fear getting separated. With the US Federal Reserve and European Central Bank (ECB) now moving in the direction of lower interest rates, the Bank of England seems anxious about being left behind.
The Fed, the leader of the pack, cut rates by 50 basis points (0.5 per cent) in September, demonstrating its commitment to moving swiftly in the direction of lower rates. The market took note and is expecting US interest rates to fall by another 120 basis points over the coming year.
The ECB, usually a slower-moving beast, is sticking close to the Fed. Although the interest rate cut delivered in October was smaller, at 25 basis points, it came with the promise of more. The market expects a further 114 basis points on the path to lower rates within the next twelve months.
The Bank of England, a smaller creature in the pack, appears keen to stay with its larger peers. Last month the governor declared that it could also deliver “more aggressive” interest rate moves if inflation data allows.
As in the wild, there are often good reasons for a central bank to stay in the herd. For example, it can make sense if an economic shock is global. The spillover effects of others’ actions can also justify following suit. For instance, a central bank that keeps its interest rates higher may attract global savings, putting upwards pressure on the currency, which can harm export prospects.
The global forecasting community, often keen to pounce on public officials that make a policy mistake, can also encourage a desire to follow the herd.
Over the coming year, however, I think it would be more risky for the Bank to follow its peers in taking interest rates meaningfully lower. Although headline inflation has fallen in the US, eurozone and UK on the back of lower energy prices, the behaviour of the UK economy suggests that underlying inflation will remain much stickier here than elsewhere.
In the eurozone, the long-awaited post-pandemic, post-energy crisis recovery already looks to be losing momentum. Germany’s manufacturing sector is struggling and the continued weakness in the Chinese economy is a key part of this story.
Not only are Chinese businesses and households not demanding the capital and luxury goods that Europe typically supplied, but they are also trying to compete against Europe by sending out discounted products to other regions. As European companies try to keep up, inflationary pressures are fading fast. With governments facing pressure from the European Commission to cut back, the pressure is on the ECB to stop the region sinking back to levels of inflation that are too low.
In the US the situation is different. Demand is proving robust, with corporations and consumers in good financial health. Inflation pressures have eased because the supply side of the economy has grown to accommodate such robust demand.
There have been two sources of additional supply of US workers. A larger proportion of the domestic working-age population is choosing to be active in the labour market. This is particularly stark in the female and older age categories. The optimistic take on this is that new post-pandemic flexibilities have made it easier for these individuals to manage their health and other priorities alongside work. The other take is that the increasing cost of living has forced more people into employment. Either way, this is an additional two million workers since the start of 2023.
There has also been an enormous increase in migration. In the US migrants who are applying for the right to remain are eligible to work after five months and are given very little in the way of income support, pushing them to seek employment as soon as possible. The exact numbers are unknown but the estimate is somewhere between 4.5 million and 6.5 million since the start of 2023.
These additional workers have eased the pressure on wage growth for businesses. What has helped those businesses even more is that workers, on average, have become more productive meaning that the cost of producing a unit of output in the US has barely grown over the past year.
How does the UK fit into this picture? The economy is growing at rates that are close to trend according to the latest GDP data. The housing market is recovering, which should further add to consumer confidence and spending. And although taxes were raised in last week’s budget, public spending plans, particularly in the near term, were raised by considerably more. Unlike the ECB, there is not an obvious need to stoke demand.
The difference with the US is in the behaviour of our supply side, particularly our labour market. The US participation rate has risen by 0.6 percentage points while ours has fallen by 1.1 percentage points from pre-pandemic levels. For reasons that are hard to pinpoint, 7 per cent of the UK population of working age cites long-term sickness as the reason for being unable to work. That is 2.6 million people.
The UK has had meaningful migration, although not of the magnitude seen in the US. Differences in the support and processing of migrants also means that a smaller proportion have entered the labour market.
Compounding the problem, productivity in the UK is still dismally stagnant. Taken together and adding in the past 10 per cent rise in the minimum wage and a further 7 per cent on the way, unit labour costs are still running north of 5 per cent year-on-year. With demand robust, we are highly likely to see these costs passed on. I am therefore anticipating that after this brief reprieve from lower energy prices, headline inflation in the UK will be on the rise again throughout 2025.
Although some modest reduction in interest rates may make sense, the Bank of England should therefore resist the temptation to follow the ECB and Fed with big cuts. It is always tempting to stay in the herd, but this will not shield the UK from the continued threat of persistent inflation.
Karen Ward is chief market strategist for EMEA at JP Morgan Asset Management