Bank of England expected to hold key rate at 3.75% as U.K. economy weakens

The Bank of England is widely expected to hold its key interest rate at 3.75% when the Monetary Policy Committee concludes its two-day meeting Thursday, a decision that would keep the central bank on a different course from the European Central Bank, which raised its benchmark rate a week earlier. The ECB’s increase — its first in more than three years — was driven by an inflation pickup linked to elevated energy prices from the ongoing conflict in the Middle East.

While the BOE is also contending with higher energy costs, most of its policymakers see clearer signs of economic weakness than their counterparts in Frankfurt. Figures released Friday showed the U.K. economy contracted in April, after starting the year with growth. The eurozone economy also recorded a contraction in the first quarter, but ECB President Christine Lagarde attributed that to what she called a “temporary” setback in Ireland and added that growth is not under “significant threat.”

“We think those advocating for a hold at next week’s meeting will signal that they remain open to tightening policy later this year,” said Edward Allenby, an economist at Oxford Economics.

The decision is unlikely to be unanimous. BOE Chief Economist Huw Pill is expected to vote for raising the key rate to 4% from 3.75%, and a number of economists expect Megan Greene to join him, with other dissents possible.

For now, however, a majority of the MPC’s nine members sees only a moderate risk that the rise in energy prices since the Iran war began will lead to a pickup in wages that prompts businesses to raise their prices to protect profit margins. They assess a jobs market that has weakened significantly in recent months, making workers more cautious about pushing hard for pay increases. Consumer demand remains weak, and policymakers doubt that businesses will risk losing customers by raising prices rapidly.

A survey conducted by the BOE in April found that most U.K. businesses expected their profit margins to shrink as a result of the war, an indication that they do not believe they have significant pricing power. “We doubt businesses will be able to make a series of price hikes stick or be able to afford to raise wage growth,” said Ruth Gregory, an economist at Capital Economics.

The BOE’s key rate was at a level that policymakers judged to be restraining activity and cooling inflation when the Iran war began. They had been expecting to cut it by half a percentage point this year. By contrast, the ECB’s key rate was at a level that neither restrained nor encouraged growth, and policymakers had appeared content to leave it unchanged.

A number of BOE policymakers have argued in recent speeches that simply removing the prospect of future cuts has already tightened policy, a restraint on activity reinforced by a sharp rise in government bond yields that has made borrowing more expensive for households and businesses. There is little immediate desire to add to that tightness in the absence of clear signs of second-round effects.

Whether the BOE raises rates later this year likely depends on the trajectory of the Middle East conflict. If the crisis is resolved soon, a rate rise appears less probable. If the Strait remains largely closed to shipping, an increase in borrowing costs becomes more likely.