Bank of England: Cutting with caution

The economist view – Melanie Baker, Senior Economist

As was widely expected and priced into markets, the Bank of England (BoE)’s Monetary Policy Committee (MPC) voted to cut rates by 25bps to 3.75%. The vote was split 5-4 again, but this time with Governor Andrew Bailey siding with those who wanted to loosen monetary policy rather than keep it on hold.

Developments since November meeting justified a cut: At the BoE’s November meeting, two camps of voters had been clearly visible with Governor Bailey emerging as the swing voter. Of the others, four “placed greater weight on the risk of persistence in inflation”, then there were four who attached more weight to downside risks. Governor Bailey noted at the time that he “would prefer to wait and see if the durability in disinflation is confirmed in upcoming economic developments this year”. Since that meeting, the unemployment rate has risen, GDP has fallen (October data) and inflation has fallen more than expected. There were also decisions taken in and around the Budget viewed by the Office for Budget Responsibility (OBR), and now the MPC, as likely to lower inflation in 2026.

All that, it seems, was enough to persuade Bailey to vote for a cut today and for the four MPC members who wanted to cut rates last time to continue to vote for a rate cut. Bailey’s paragraph in the minutes shows that he thought “data news since our latest meeting suggests that disinflation is now more established. CPI inflation has fallen from its recent peak and upside risks have eased. Measures in the Budget should reduce inflation further in the near term.”

In the meeting minutes there was support for the idea that this is not the end of the bank’s cutting cycle, but that more evidence of disinflation will be needed. The overall tone was more cautious than dovish.

More rate cuts ahead, but more evidence required first: There were a few elements of the decision and minutes of the meeting that support the idea that this is not the end of the bank’s cutting cycle, but that more evidence of disinflation will be needed. The overall tone was more cautious than dovish:

• Comments in the overall meeting summary were dovish: “The risk from greater inflation persistence has become somewhat less pronounced since the previous meeting, while the risk to medium-term inflation from weaker demand remains”…
• …However, the summary modified the line about “if progress on disinflation continued, Bank Rate was likely to continue on a gradual downward path”. Now, that reads: “On the basis of the current evidence, Bank Rate is likely to continue on a gradual downward path. But judgements around further policy easing will become a closer call.”
• Bailey’s own comments were somewhat balanced, noting that they should be vigilant around a possible sharper decline in the labour market but also noting risks that inflation could prove more persistent. However, he sounds inclined towards further rate cuts, albeit with a strong dose of caution: “While I see scope for some additional policy easing, the path for Bank Rate cannot be pre-judged with precision, recognising in part the more limited space as Bank Rate approaches a neutral level.”
• The minutes separate the group of five MPC members voting for a rate cut with two (Swati Dhingra and Alan Taylor) attaching greater weight to downside risks but the other three (Andrew Bailey, Sarah Breeden and Dave Ramsden) sounding more circumspect (“they would continue to assess incoming evidence, particularly around labour market activity and wage growth”). Breeden commented that “looking ahead, I will need a greater accumulation of evidence on disinflation as we feel our way towards neutral next year”. Ramsden, meanwhile, said there “could be scope to slow this cadence of easing in due course”. 

As inflation falls further – as I think it will next year – I expect the BoE to cut rates further in 2026. There are clearly risks to this view, however:

• First, a substantial chunk of the MPC continues (for now) to vote against rate cuts.
• Second, there are clearly risks that inflation and inflationary pressure do not slow at the pace I expect over 2026. The fears of some of the hawks are valid and indicators like pay growth and service inflation – for now at least – remain above inflation-target consistent levels.

The fund manager view – Ben Nicholl, Senior Fund Manager

Bank of England: Bailey’s Christmas gift

At Thursday’s Bank of England (BoE) meeting, the committee voted to cut interest rates by 0.25%, from 4% to 3.75%, in what was a highly anticipated decision. The only real point of contention was what the vote split would be; would one or even two of the more hawkish members be swayed by the recent weakness in the economic data and vote to reduce rates, or would it just be Governor Andrew Bailey that joined the doves. In the end only Governor Bailey shifted from their position at November’s meeting, leaving the committee split 5-4 in favour of a 0.25% reduction in interest rates. The bond market reaction was relatively muted, with yields on 2-to-5-year maturity gilts a little higher after the meeting as the markets reappraised the probability of an additional cut as early as February 2026. Longer term, the market still anticipates interest rates in the UK to settle somewhere between 3.25% and 3.5% by the end of 2026, a level that has remained relatively unchanged by markets for some time now.

While some of the weakness in the recent economic data has been attributed to speculation around the UK Budget that took place on 26 November, and the potential impact of Chancellor Rachel Reeve’s fiscal policy choices on the economy, the data has been trending weaker for some time. UK GDP has been slowing since Q1 2025, with the latest month on month print for October GDP of -0.1%. Unemployment too has drifted steadily higher since last year’s Autumn Budget, rising from 4.3% in October 2024 to 5.1% in October of this year, its highest level since the peak of the Covid pandemic in 2020. And Consumer Price Inflation (CPI) has been falling since the summer highs, with recent prints undershooting versus both the market and BoE’s expectations. Most importantly though, market expectations are for CPI to be at or just above the BOE’s 2% target in April 2026, when more of the base effects of last year’s Budget fall out the calculation; just a few months ago, that market estimate for April 2026 CPI was around 2.6%.

Markets are forecasting that UK interest rates should settle a little lower, but the risk reward is tilted towards even lower rates than the market is pricing over the next 12 months.

The economic trend is clear: growth is anaemic, the labour market is weakening, and inflation is now cooling. Yes, the markets are forecasting that UK interest rates should settle a little lower than here, but the risk reward is tilted towards even lower rates than the market is pricing over the next 12 months. We think UK government bonds remain attractive both outright but also relative to other global markets, especially at the longer end, where 30-year maturity gilts yield 5.3%, and where the market is set to be starved of any true longer maturity gilts till at least Q2 2026.

European Central Bank: On Ho Ho (Ho)ld for now

As widely anticipated, the European Central Bank (ECB) opted to keep rates unchanged at their meeting on 18 December, with the deposit rate holding steady at 2.0%. The decision was unanimous, reinforcing the sense of stability in policy. Consensus expectations remain firmly anchored: the ECB is likely to stay on hold throughout 2026, and nothing in the announcement, statement, or press conference suggests otherwise.

Inflation in the euro area remains close to 2%, and while the latest staff projections for 2026 ticked higher, reflecting stronger domestic demand, the medium-term picture remains benign. Headline inflation is forecast at 1.8% in 2027, reaching the 2.0% target by 2028. The ECB reiterated its familiar mantra: policy decisions will remain data-dependent, assessed meeting by meeting, with no pre-commitment to a specific rate path. President Chrstine Lagarde again described monetary policy as being in a “good place,” though clarified this does not mean “static”.

Lagarde confirmed there was no discussion of rate hikes or cuts today, but stressed unanimity on keeping all options on the table.

Lagarde confirmed there was no discussion of rate hikes or cuts today, but stressed unanimity on keeping “all optionalities on the table”. This flexible approach allows the ECB to be reactive where required, wages have surprised to the upside recently, but indicators still point to a likely slowdown in 2026. Questions on the recent upside surprise in euro area activity highlighted exports and investment, including AI-driven private investment as key contributors. These factors could sustain momentum, but for now, they do not appear enough to alter the ECB’s stance. 

Lagarde faced queries on succession, despite her term running until 2027. One notable point: whether a sitting executive board member, such as Isabel Schnabel, could legally become ECB president. Lagarde noted past legal advice suggested not, but hinted this could be revisited.

With the ECB signalling an on-hold stance, we feel eurozone government bond yields are likely to remain range-bound for the time being. The front end should stay reasonably anchored, while any upward pressure on long-end yields will depend on growth surprises, fiscal dynamics and changes to the long-term neutral interest rate. A steeper curve bias is likely to ensue on Dutch pension reform flows, which will pick up pace in 2026 and run into 2027. This will continue to put upward pressure on longer dated yields, as schemes switch from defined benefit to defined contribution.  

The ECB remains firmly in “wait-and-see” mode. Inflation is broadly under control, growth is resilient, and policy optionality is intact. For now, the message is clear: rates are on hold, and the ECB is comfortable with where it stands.

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