ROI-BoE needs to rein in rising real rates: Mike Dolan

By Mike Dolan

LONDON, Dec 18 (Reuters) - If British growth is sub-par, its labor market weakening and fiscal policy tightening, then the Bank of England looks behind the curve - and should now be playing catch-up to offset tightening real interest rates as inflation tumbles anew.

Wednesday's rare positive inflation surprise for November seemed to seal market expectations for today's likely quarter-point BoE rate cut - its fourth of the year.

"A Christmas rate cut looks all but certain," said Deutsche Bank's Sanjay Raja. "More rate cuts will likely follow in 2026."

Barclays chimed and said the inflation slide "removes the final hurdle that could likely have, in our view, dissuaded the BoE from cutting (the) bank rate".

But forecasters were already there before the inflation news anyway - especially after last month's critical government budget went off without fireworks and reined in government budgets over the next five years.

All 64 polled by Reuters earlier this month went for a quarter-point cut to 3.75% - none opted for a 50-basis-point cut.

Might a deeper rate cut actually be warranted this week?

The main obstacle appears to be a fairly narrow 5-4 vote in the Bank's policy council at its last meeting - even though there's plenty of speculation that at least one of the committee members may indeed push for a half-point reduction this week.

But a case for the BoE to move faster may be building.

TIGHTENING REAL POLICY RATES

The uncomfortable midyear spike in headline inflation - largely due to one-off regulatory price shifts - has subsided now to 3.2%. It hit that level four months earlier than the BoE forecast only last month.

In doing so, it's effectively converged with headline U.S. inflation again for the first time since spring, even though it's still a point above the euro zone equivalent and well above the 2% target.

And yet, wisely or not, the Federal Reserve has resumed easing with gusto of late and cut U.S. rates three times since September - and it's doing so into an economy growing twice as fast as the UK's and set to receive another wave of fiscal stimulus next year.

The U.S. and British economies are vastly different in scale and drivers, of course, but Fed rates are now lower than UK rates for the first time this year and two more Fed cuts are priced for next year.

Even given distortions in UK inflation stats, the more worrying thing for the BoE is that its own "real", inflation-adjusted policy rate is tightening sharply over the past three months - up about 60 bps since September following November's inflation surprise.

That may not be a place the BoE will want to linger for long unless it expects some re-acceleration of either inflation or GDP growth over the next year - neither of which were in its central projections in last month's Monetary Policy Report.

Even after Thursday's cut, the real UK policy rate will still be more than 0.5%.

Although in positive territory since the scramble to tamp down post-Ukraine invasion inflation spikes, that real UK policy rate has averaged minus 1.1% over the past 20 years.

And, by contrast, the European Central Bank's equivalent real rate is now at zero.

NEW NORMAL OR FOOT DRAGGING?

So if there's no jumbo cut on Thursday, surely rapid-fire BoE rate cuts are in the pipeline?

Even after Wednesday's inflation boon, markets fully price in only one further quarter-point BoE rate cut next year - with a notional "terminal rate" hovering about 3.35%.

And that additional cut is not fully priced until the April 30 meeting, despite two meetings before then earlier in 2026.

Even one of the BoE's "scenario" forecasts for "weak demand" next year sees rates bottoming only as low as 3%. And given its standing forecast for inflation to be back to 2% by 2027, that still leaves a "real" terminal rate of some 1%.

The BoE's arguments for that horizon hover around uncertainties about slack in the economy and related big variations on where a "neutral" rate may now lie - and hence what level of restriction current rates have on activity.

Maybe the British economy does just fine and the post-pandemic world is on a new trajectory that positively warrants higher interest rates.

Or maybe structural hits to its economic potential - primarily from Brexit, but also from energy supply shocks and other supply bottlenecks in labor markets or construction - have made it harder to loosen credit too much before stoking inflation again. The speed limit for the economy, as some economists like to put it, may simply be lower.

But there may also be an argument that all the noise of the past five years has fogged up the dashboard and the fundamentals of the economy have not changed all that much since the pandemic.

If so, the BoE may be dragging its heels unnecessarily.

The opinions expressed here are those of the author, a columnist for Reuters

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(by Mike Dolan; Editing by Marguerita Choy)