(Feb 6): The Bank of England’s (BOE) monetary policy committee (MPC) voted to cut interest rates to a 19-month low but struck a hawkish tone by signalling that only two more reductions are needed to bring inflation back to the 2% target.

In a blow to Chancellor of the Exchequer Rachel Reeves, the BOE warned that inflation will rise “quite sharply” to peak at 3.7% later this year, up from 2.8% in the last forecast, as it downgraded growth and its estimate of the economy’s growth capacity, or speed limit, in the short term.

The MPC lowered its benchmark rate by a quarter point to 4.5%, the lowest level since June 2023, in a reprieve for the more-than-half-a-million homeowners coming off five-year fixed mortgage deals in 2025. Seven of the nine members voted for a quarter-point cut but two, the external policymakers Swati Dhingra and Catherine Mann, wanted a half point reduction. It was the first vote for a cut by Mann, who has taken an "activist” approach.

“It will be welcome news to many that we have been able to cut interest rates again,” Governor Andrew Bailey said. “We’ll be monitoring the UK economy and global developments very closely and taking a gradual and careful approach to reducing rates further.”

Still, the MPC added the word “careful” to its core guidance, indicating that the risks are now two-sided. “A gradual and careful approach to the further withdrawal of monetary policy restraint was appropriate,” the MPC minutes said. “There are uncertainties around the trajectories of both demand and supply in the economy that could have implications for monetary policy.”

Economists had expected an 8-1 split with Mann still supporting a hold in rates, so the vote was surprisingly dovish. However, updated forecasts in the Monetary Policy Report painted a slightly more hawkish picture.

The market path for rates used to build the forecast has just two further cuts over the next three years, with policy settling at 4%. Only one more cut is fully priced for this year to 4.25%. Under that scenario, inflation returns to target in the fourth quarter of 2027.

The implication is policy needs to be much tighter than the four cuts this year to 3.75% that the BOE signaled in November and Bailey appeared to endorse in December. A higher path of inflation was to blame, driven by energy and water bills and regulated prices like bus fares.

Also behind the change was a downgrade to the bank’s estimate of UK growth capacity, which makes faster growth inflationary. It halved its estimate to 0.75% this year but expects potential growth to return to 1.5% from 2026. The bank blamed the downgrade on persistently weak productivity and suggested Labour’s increased spending on the National Health Service may make the position worse.

The bank’s outlook is a bleak backdrop for Reeves, who has presided over a collapse in growth since Labour won the general election last July. The BOE believes the economy contracted 0.1% in the three months to December, the quarter that included Reeves’ tax-raising budget on Oct 30, and will grow just 0.1% in the first quarter of 2025.

The growth forecast for this year has been halved to 0.75% but picks up to 1.5% in 2026 and 2027, from the prior projection of 1.25% in both years. The bank said its forecast is “not conditional on any change in global tariffs” but that a trade war could depress UK growth by “delaying investment spending and hiring decisions.”

Reeves’ budget tax rises, including a £26 billion increase in employers’ National Insurance Contributions, are weighing on the short term outlook. Business sentiment has been “weak” and if that persists growth could be even worse than expected, the BOE warned.

There were no material changes to the bank’s forecasts following Reeves’ recently announced plans to boost growth by relaxing regulations and waving through infrastructure projects.

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