BOE to Deliver Setback for Reeves With ‘Stagflation’ Forecasts

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(Bloomberg) — The Bank of England is expected to deal Rachel Reeves a blow this week by downgrading its growth outlook and warning that her October budget will drive up inflation just days after the Chancellor of the Exchequer unveiled a huge package of measures to boost the economy.

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While the UK central bank is expected to offer some help by cutting interest rates for a third time since August on Thursday, its new forecasts are likely to reinforce fears that the UK is in the grip of stagflation, according to economists.

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Those surveyed by Bloomberg unanimously expect the BOE to reduce rates a quarter point to 4.5%, the lowest level since June 2023. Eight of the nine Monetary Policy Committee members are expected to continue with a “gradual approach” to loosening policy. Catherine Mann, an external member, is expected to vote to leave borrowing costs unchanged.

“It’s clear that growth has materially weakened, meaning the MPC will probably downgrade its growth forecasts for this year,” said Thomas Pugh, economist at accountants RSM. “However, inflationary pressures are now rising again.” He predicts a total of four rate cuts this year to 3.75%, while markets are priced for three.

The BOE is caught somewhere between the US, where strong growth and inflationary pressures last week forced the US Federal Reserve to pause rate cuts, and the eurozone, where the European Central Bank cut rates for a fifth time last Thursday and warned of stalling growth. 

“The bank in its upcoming projections will likely face a more tricky inflation and growth trade-off,” said Matt Swannell, chief economic advisor to the EY Item Club in an interview. 

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Ahead of the BOE decision, the Item Club downgraded its UK growth forecast for 2025 to just 1% from 1.5%, according to a report published Monday. Inflation is seen remaining above the BOE’s 2% target over the next 12 months, adding to warnings that the UK is drifting into a trap of anemic growth and sticky inflation.

“The UK lost momentum at the end of 2024 so that leaves it a bigger hill to climb to achieve growth in 2025,” Swannell said. Business investment, a key part of Labour’s growth plan, will also take a hit. EY trimmed its investment growth forecast to 2% from 3% amid heightened economic uncertainty, elevated borrowing rates and the government’s employment tax hikes.

Last week, Reeves announced planning and regulatory reforms and gave the green light to a raft of infrastructure projects including a controversial third runway at Heathrow airport in a bid to resuscitate growth. 

Growth will be the government’s “number one mission,” she said as she sought to end the gloomy narrative of Labour’s first six months and respond to the backlash against her tax-raising October budget. The economy has stagnated since Labour won the general election in July.

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Beyond the anticipated rate cut, the BOE’s February Monetary Policy Report is unlikely to provide much support. It will update its assessment of the impact of Labour’s £26 billion ($32.4 billion) payroll-tax hike on employers. Bruna Skarica, a UK economist at Morgan Stanley, said recent evidence suggests firms will pass more on to prices than the BOE thought in November.

That, alongside higher food and energy prices, may see the BOE increase its inflation outlook in the first half of this year by 0.3-0.4 percentage points, she said. Bank of America economists believe the BOE will revise down its growth forecasts in both the short and long term “to reflect recent weak outturns, weak confidence, and higher Bank Rate path.” In November, the BOE was forecasting 1.5% growth this year. The consensus is now 1.3%.

The bank’s convention of using the market path for rates to build its growth and inflation forecasts threatens to complicate the communication on Thursday. Markets were betting on three quarter-point rate cuts this year on Friday but the bank’s forecasts may have closed when only two were fully priced. Both are fewer than the four cuts the bank’s November forecasts and Governor Andrew Bailey effectively endorsed.

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The Bank of America economists said the MPC could “signal an implicit pushback against market pricing” by showing inflation falling in its forecasts further below target in two or three years’ time. However, that would imply the bank’s growth forecasts, which also use the market path, understate the UK’s actual prospects, unnecessarily undercutting the Chancellor.

Former US Federal Reserve Chair Ben Bernanke has said the bank should consider using its own forecast for rates instead because the current convention risks “clouding the interpretation of what the committee is trying to say.” The BOE has said it plans to use “scenarios” instead. 

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