Bank of England turns dovish: allows inflation to temporarily exceed target, signals lower probability of rate hike in June

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Bank of England Governor Bailey sends a clear dovish signal, stating that against a backdrop of economic weakness, the central bank can tolerate inflation staying above the 2% target for a period—this statement has greatly cooled market expectations for a rate hike in June.

On May 29, Bailey delivered a speech at an economic conference in Reykjavik, Iceland, clearly stating, "Against the backdrop of a weak real economy and uncertainty regarding the scale and duration of shocks, tolerating inflation temporarily above the target to support the real economy is the appropriate way to handle this trade-off." However, he also warned that if signs of second-round effects appear, this tolerance will diminish.

This means Bailey is unlikely to support a rate hike at the Bank of England's Monetary Policy Committee meeting on June 18. The market reaction has adjusted accordingly—the interest rate swap market now only prices in one 25 basis point rate hike by the end of 2026, whereas by late April, the market was expecting three rate hikes this year.

The surge in energy prices triggered by the Middle East situation has put the UK at risk of a second cost-of-living crisis in less than five years. Bailey's remarks indicate the Bank of England is prioritizing preventing further economic downturn, but the high uncertainty of the inflation outlook leaves policymakers walking on eggshells.

Removal of Rate Cut Expectations Constitutes Substantial Tightening

Bailey stated, by abandoning the previous market-expected rate cut path, the Bank of England has actually tightened its policy to a considerable degree.

Before the US and Israel launched attacks on Iran at the end of February, investors expected the Bank of England to cut rates by 50 basis points this year, in two moves. After the conflict erupted, expectations reversed to a hike of the same magnitude. This shift pushed UK government bond yields sharply higher, raising borrowing costs for households and businesses.

"By removing the anticipated rate cuts from the table, we have already tightened policy significantly relative to market expectations, and this is impacting the economy," Bailey said. This means that even if the central bank keeps rates unchanged, the substantive tightening of financial conditions is already cooling inflation, justifying a hold.

Economic Pressure: Energy Shock Saps Consumption and Investment

The rise in energy prices caused by the Middle East conflict is dragging down the UK economy on multiple fronts. The latest data shows consumer spending is down, companies are postponing investment, accumulating inventory, and cutting staff. High energy costs compounded by domestic political uncertainty are clearly weakening economic momentum.

Purchasing manager survey data corroborates this—surveys released this month show that commercial activity slowed sharply after a strong start to the year. Meanwhile, the labor market continues to loosen up. Bailey said in the Q&A session: "The picture of a gradually softening labor market is presenting itself fairly consistently."

The UK inflation rate dropped from 3.3% in March to 2.8% in April, but analysts point out this is largely due to a one-off measure announced by the government in November. The Bank of England expects inflation to rebound in the coming months.

Second-Round Effects: The Core Variable of Policy Dilemma

Though Bailey leans toward keeping rates steady, he remains highly vigilant about the risks of second-round effects. Second-round effects refer to energy price shocks driving up wages sharply, prompting companies to raise prices again and creating an inflation spiral.

Bailey acknowledged divisions within the Monetary Policy Committee over this issue. Some members worry wages in the UK will rise too fast next year, while more dovish colleagues believe rising unemployment will suppress this risk. Bailey noted that since most wage agreements were finalized before the conflict broke out, the central bank will have very limited wage data in the coming months, which could lead to a situation where inflation expectations rise but wage growth does not accelerate accordingly.

He also cited the lesson from four years ago—when inflation surged to double digits due to the Russia-Ukraine conflict. "Since second-round effects take longer to transmit, there are even fewer reasons to look through indirect effects; if indirect effects last too long, unless monetary policy responds in time, inflation will be above target for a long time," Bailey said.

Market Reaction: Rate Hike Expectations Cool Sharply

Throughout May, market expectations for a rate hike by the Bank of England have dropped sharply. The interest rate swap market now only prices one 25 basis point hike by the end of 2026, a significant shift compared to the three rate hikes expected in late April.

After Bailey's remarks were released, the initial market reaction was muted. He will then be interviewed by Stephanie Flanders, Bloomberg's editor-in-chief for economics and government affairs, where more policy clues may be provided.

The June 18 Monetary Policy Committee meeting will be the next key event. Bailey's statement provides a clearer signal toward holding rates steady, but the evolution of the inflation outlook—especially energy prices and wage data—will remain key variables for policy direction.

Risk Warning and DisclaimerThe market has risks, and investing requires caution. This article does not constitute personal investment advice, nor does it take into account individual investment goals, financial status, or needs. Users should consider whether any opinions, views, or conclusions in this article fit their particular situation. Investing based on this is at your own risk. ```