Bank of England faces inflation challenge as it prepares to cut rates

By David Milliken

LONDON (Reuters) -The Bank of England is widely expected to cut its key interest rate to 4% from 4.25% on Thursday and to lower it once more before the end of the year, despite consumer price inflation rising to close to double the central bank's 2% target in June.

But policymakers are divided over how much underlying price pressures are easing, and on whether a slowing labour market and sputtering growth will make inflation undershoot its target in the medium term if rates are not cut further.

The following graphics set out some of the issues policymakers are likely to discuss before Thursday's decision.

GLOBAL CONTEXT AND OUTLOOK

British inflation surged more than in the euro zone or the United States after Russia's full-scale invasion of Ukraine in 2022, hitting a peak of 11.1%, partly due to Britain's heavy reliance on natural gas for heating and electricity.

Inflation fell sharply in 2023 and bottomed out at 1.7% in September 2024. But since then it has picked up more than in the United States or euro zone and in May the BoE forecast it would not be back to target until early 2027.

Inflation rose to 3.6% in June, its highest since January 2024, and some economists think it will soon hit 4%.

By contrast, the European Central Bank expects euro zone inflation to hover just below 2%.

RISING INFLATION EXPECTATIONS

Most BoE officials view surveys of businesses and households' expectations for future inflation as an important guide to future price rises and wage demands, and even of the central bank's credibility.

These measures have climbed over the past year. The Citi/YouGov measure of long-term expectations is near its highest since late 2022 - when headline inflation was in double digits - while the BoE's own survey is at its highest since 2019.

However, some officials place less weight on these surveys, viewing responses as a reaction to recent inflation rather than a prediction of future behaviour.

PERSISTENT DOMESTIC INFLATION

While headline consumer inflation fell sharply in 2023 before beginning to rise again, two components often used as a gauge of longer-term domestic price pressures have not dropped as much.

Both services price inflation - which is heavily affected by increased labour costs - and core CPI, which strips out volatile elements - have stayed higher than headline inflation.

Separately, food and drink inflation - which has a big impact on public perceptions of inflation and is especially noticeable for poorer Britons - has begun to pick up rapidly.

WAGE GROWTH HIGH BUT SLOWING

Annual private-sector regular wage growth of just under 5% has slowed from a peak of more than 8% two years ago. But it is still about 2 percentage points higher than before the COVID-19 pandemic and the roughly 3% level which most policymakers view as consistent with 2% inflation.

Both the central bank itself and employers surveyed by the BoE expect pay growth to slow further towards 3% over the next 18 months, putting downward pressure on inflation.

But the drop in wage growth over the past year has not been smooth and rising unemployment and fewer job vacancies are not a guarantee that wage growth will slow as fast as the BoE expects.

PMI DATA SHOWS RISING COST PRESSURES

Purchasing Managers' index data for July showed British businesses were raising prices at a "robust pace" according to S&P Global which collects the monthly data.

While down from 2022, the survey still shows bigger price increases than before the pandemic. Over the past year, costs for both services businesses and manufacturers have risen sharply - which will put upward pressure on prices if these are passed on to consumers.

(Reporting by David Milliken; editing by Diane Craft)