Bank of England Interest Rate Decision September 2025 - My Take

Key Concepts

• Monetary Policy Committee (MPC): The Bank of England's committee responsible for setting interest rates and other monetary policy tools.
• Bank Rate: The official interest rate set by the Bank of England.
• Quantitative Tightening (QT): The process of reducing the size of a central bank's balance sheet by letting assets mature or selling them.
• Guilts: British government bonds.
• Yield Curve: A graph showing the yields of bonds with different maturities. A steepening yield curve indicates that long-term yields are rising faster than short-term yields.
• Disinflation: A decrease in the rate of inflation.
• Labor Slack: The difference between the potential labor force and the actual employed labor force, indicating underutilization of labor resources.
• Stagflation: A combination of high inflation and low economic growth.
• CPI (Consumer Price Index): A measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.
• National Insurance Contributions (NICs): Taxes paid by individuals and employers in the UK.
• Money Market Funds: Mutual funds that invest in short-term, low-risk debt instruments.
• Sonia (Sterling Overnight Index Average): A benchmark interest rate for sterling overnight transactions.
• Capital Gains Tax: Tax on profits made from selling an asset.

Bank of England MPC Decision and Rationale

The Monetary Policy Committee (MPC) of the Bank of England decided to hold the Bank Rate at 4%. This decision was not unanimous, with 7 members voting to keep rates unchanged and 2 members voting for a 0.25% reduction to 3.75%. This contrasts with the previous meeting where a cut was decided by a narrow margin.

The MPC's decision is influenced by the UK's economic situation, characterized by weak growth and inflation that has been ticking up but is expected to start falling from its peak in Q3 of this year. While the official mandate focuses on price stability (inflation), the MPC also considers economic growth.

Key Factors Influencing the Decision:

• Disinflationary Progress: There has been progress towards the 2% inflation target over the past two and a half years, attributed partly to restrictive monetary policy and external factors like lower energy prices.
• Inflation Outlook: Inflation was 3.8% in August and is expected to rise slightly in September before falling towards the 2% target.
• Wage Pressures: While wage pressures have eased somewhat due to labor market slack, they remain elevated. The triple lock on state pensions, which includes wage growth, contributes to this.
• Labor Slack: The UK economy is experiencing increased labor slack, meaning more people are available for work than there are available roles. This is a consequence of weak economic demand and is expected to help bring down wage growth, though it signifies a painful economic slowdown.
• Economic Conditions: Hiring and employment momentum are weak, and pay growth, though elevated, is declining.
• Global and Geopolitical Risks: A global economic slowdown due to trade tariffs or political uncertainty could dampen UK growth and inflation. The current situation in the UK is described as potentially stagflationary, with reasonably high inflation (around 4%) and very weak growth.

Bank of England's Quantitative Tightening (QT) Strategy

A significant difference between the Bank of England and the Federal Reserve's approach to QT is highlighted. While the Federal Reserve passively lets its bond holdings mature, the Bank of England actively auctions off its gilts. The MPC has decided to slow down the rate at which it sells long-dated gilts. Previously, about a third of their sales were long-dated bonds; this will now be reduced to about a fifth. This decision is made amidst concerns about movements in the long end of the yield curve, where yields are picking up and bond prices are falling. The rationale for slowing sales, even if they claim it doesn't distort the market, is considered somewhat suspicious.

Inflation Drivers and Risks

• External Price Shocks: Energy prices have been a major input cost for the UK economy, and their reduction has contributed to disinflation.
• Food Prices: Despite forming a smaller part of most consumption baskets, food prices have a significant psychological impact on inflation expectations.
• Administered Prices: Prices like water bills and vehicle excise duty, which are influenced by government policy, have also contributed to recent inflation increases.
• National Insurance Contributions (NICs): An increase in employer NICs is cited as a factor delaying the reduction in total labor cost growth.
• Wage Growth: Persistent high wage growth is seen as a risk for embedding structurally higher inflation long-term.
• Service Inflation: Remains high at 4.7%, driven by wages.
• Goods Inflation: Has moved from negative territory to positive, indicating an acceleration that is a cause for concern.

Economic Data and Market Reactions

• Bank Rate History: The current Bank Rate of 4% is below the historical median of 5% over the Bank of England's 300-year history. The recent rate increases were a response to a sharp inflation spike, and the current cuts are slower due to "sticky inflation" and wage growth.
• Sterling vs. Dollar: Sterling fell against the dollar following the announcement of no rate cut, which is a standard reaction.
• UK Gilts: A small fall in UK gilts was observed, with yields increasing slightly. The market had largely priced in the decision to hold rates.
• Yield Curve Steepening: The long end of the yield curve (e.g., 20-50 year bonds) is experiencing rising yields and falling prices, while the short end is responding to monetary policy. This has led to a steepening of the yield curve, returning to a pre-financial crisis pattern of a high and steep curve.

Specific Examples and Anecdotes

• Chocolate Inflation: The speaker humorously notes high chocolate inflation, exemplified by a large "big daddy pistachio bar," highlighting that certain food inflation remains high and disproportionately affects lower-income households.
• Andrew Bailey's Letter to Rachel Reeves: The Governor of the Bank of England's letter to the Chancellor is mentioned, where he attributes some of the recent inflation spike to government policies like NIC increases and minimum wage hikes, while also acknowledging external factors like energy prices.
• Personal Anecdote on Cash Interest: The speaker shares a personal experience of forgetting to enable interest on cash held in their investment platform, resulting in six months of no interest earned. This serves as a cautionary tale about checking platform settings.

Investment and Cash Management Advice

• Short-Term Market Forecasting: The speaker advises against trying to forecast stock movements over short horizons (one day, one month, or even one year), suggesting a focus on long-term investment strategies.
• Cash Management: For those holding cash, options include:
  • Direct Cash Holdings: Ensuring interest is enabled on platforms, with current sterling rates around 4.05%.
  • Money Market Funds: Benchmarked against Sonia (currently around 3.97%), these funds offer a slightly lower rate than direct cash but are subject to fluctuations as bank rates are cut.
  • To Maturity Gilts: These are presented as a tax-efficient option, especially for general investment accounts, as capital gains are not taxed. Holding them to maturity locks in a yield with high safety. The speaker highlights specific gilt types (e.g., TG30, TG33, TN28) with low coupons and significant capital gain components.
• Global Index Funds: Recommended for most investors due to their simplicity and ability to capture long-term market drift.
• Small and Mid-Cap Funds: The discussion touches on the composition of global index funds, noting that some, like the FTSE All-World Index, exclude small caps. Investing in dedicated small and mid-cap funds is an option, but the speaker notes the higher tracking costs associated with them due to higher churn and bid-offer spreads.

Data Quality Concerns

The speaker raises concerns about the quality of recent ONS (Office for National Statistics) data, particularly regarding jobs numbers and GDP calculations. This unreliability poses a challenge for the Bank of England, which relies on this data for its rate decisions. The inclusion of British overseas manufactured pharmaceutical products in UK GDP calculations is questioned.

Subjectivity of Inflation

The speaker acknowledges that individual inflation experiences can differ due to varying consumption baskets. While the ONS strives to create an accurate average CPI, personal inflation rates will vary. The speaker defends the ONS's efforts in constructing and updating the consumption basket, dismissing claims of a "con."

Conclusion

The Bank of England's MPC has maintained its hawkish stance by holding interest rates steady, signaling a cautious approach to inflation despite weak economic growth. The decision reflects a complex interplay of disinflationary progress, persistent wage pressures, and global economic uncertainties. The discussion also delves into the nuances of quantitative tightening, the drivers of inflation, and practical advice on cash management and investment strategies, while acknowledging potential data quality issues impacting economic analysis.