Bank of England set to hold interest rates despite inflation hitting 2% target

LONDON — The U.K. had some cause for celebration on Wednesday morning, as headline inflation hit the Bank of England’s 2% target for the first time in nearly three years.

But the print only served to further convince traders that an interest rate cut is not imminent.

Money market pricing by 11 a.m. in London implied just a 5% probability of a trim of the Bank Rate during Thursday’s BOE meeting — after recording stronger odds of such a step earlier in the week. Bets on an August cut were also trimmed to roughly 30%.

While the 2% inflation reading is a significant milestone — not least as British politicians set out their stalls ahead of a general election in just over two weeks — it has been anticipated for some time and was largely driven by the sharp year-on-year decline in energy prices. Fluctuations in the rate over the coming months are expected as the drag from energy fades.

Policymakers are equally focused on services inflation, key to understanding domestic price pressures in the country’s services-oriented economy, which came in at 5.7% — higher than the 5.5% forecast by economists in a Reuters poll.

Core inflation, excluding the volatile components energy, food, alcohol and tobacco, remained well above the central bank’s long-term average at 3.5%.

“We’ve seen some good stuff in terms of seasonality, food prices are coming down as well,” James Sproule, chief economist at Handelsbanken, told CNBC’s “Street Signs Europe” on Wednesday.

“But looking over the rest of the year, even the Bank of England itself is expecting inflation to start to creep up a bit again over the course of the autumn,” he said.

“I think the most disturbing thing lots of economists like myself are looking at right now is what’s happening in services inflation. That’s largely about people’s salaries and earnings. And those numbers have been proving a good deal stickier than we would like,” Sproule said, with the BOE targeting services inflation of around 3%.

Whether the BOE cuts rates in August or September remains a close call, he added.

Average U.K. wage growth excluding bonuses held uncomfortably high for the BOE at 6% in June, though there were signs of a loosening labor market.

At its last meeting in May, the central bank said that recent inflation readings had been “encouraging,” but that the chance of a rate cut would be assessed at each meeting and based on the latest data.

Members of the BOE’s Monetary Policy Committee, including Governor Andrew Bailey, will be more tight-lipped than usual on Thursday due to the upcoming national vote. The institution is politically independent and has stressed it would be willing to enact a rate cut if it believed one was required, irrespective of an election.

But both the ruling Conservative Party and its main opposition Labour have centered their platforms on the U.K.’s economic performance, meaning that central bank action — or lack thereof — will be closely watched.

Two members of the MPC voted to cut rates at the May meeting, versus seven who voted to hold.

James Smith, developed markets economist at ING, expects a repeat of that split on Thursday.

“That may be hard to square against the idea that the committee is very close to cutting rates. But the key thing to remember is that the five internal committee members, who hold the key to the first cut, tend to move as a pack,” Smith said in a note on Tuesday, meaning an August rate cut would remain firmly on the table.

A BOE decision to hold rates would come after the European Central Bank began its own path of reductions at its June meeting. Headline inflation in the euro zone came in higher than in the U.K. at 2.6% in May, but the core figure has cooled further.

Economists will be listening out for BOE messaging on liquidity conditions and their impact on the economy, as well as any hints that the Bank’s confidence has been shaken by the latest data, ING’s Smith said.

“But listening to Governor Andrew Bailey back in May, it sounded like he was keen to get on with the job of cutting interest rates. And a bit like the European Central Bank, the BOE seems more confident in its inflation predictions than it had been over the past couple of years,” he added.