The Bank of England can lower borrowing costs five more times to 3.5% before it risks overheating the economy and driving inflation back up.
Estimates by Chief UK economist Dan Hanson suggest the neutral interest rate is between 3% and 4%, higher than previous expectations. He assumes the midpoint, 1.25 percentage points below the current level, will be where rates settle.
Determining where monetary policy neither restricts nor stimulates growth is increasingly important for policymakers as they aim to manage the economic impact of inflation during 2022 and 2023. The Bank of England is reversing its policy after raising rates sharply to address inflation, which briefly reached 11%.
Governor Andrew Bailey recently indicated that four quarter-point cuts in 2025 are likely, lowering the benchmark rate to 3.75% from 4.75%. However, he did not comment on the neutral rate, other than stating it will be higher than the near-zero rates seen from 2009 to 2021.
Hanson stated that further cuts beyond this point are limited without risking inflation. He now expects the Bank to make one more cut in 2026, stopping short of the 3% rate he had earlier predicted.
As central banks continue reducing rates next year, the discussion around the end point of the easing cycle is expected to intensify. Both the European Central Bank and the US Federal Reserve have modelled neutral scenarios, but the Bank of England has not revisited this topic since 2018, when it estimated the neutral rate to be between 2% and 3%.
Deputy Governor Clare Lombardelli recently noted that the neutral rate is “unobservable” and suggested it would not be practical to estimate it.
Swati Dhingra, the most dovish member of the Monetary Policy Committee, stated that the neutral rate has increased to somewhere between 2.5% and 3.5%.
Catherine Mann, the most hawkish member, believes the neutral rate has risen, meaning the current policy setting is less restrictive than assumed.
Charles Goodhart, a former member of the MPC, earlier this year suggested the long-term neutral rate could be slightly above 4%.
Hanson used a method similar to the one employed by the US Federal Reserve, which took into account the UK economy’s resilience to the sharp rate increase from 0.1% to 5.25% over 20 months. He noted that the economy has performed better than most models would predict.
According to Hanson, about half of the rise in the Bank of England’s policy rate seems to have been matched by an increase in the neutral rate, which explains much of the economy’s resilience to higher rates and has significant implications for future borrowing costs.
