The Bank of England has kept interest rates unchanged at 3.75%, but as inflation falls, the real interest rate—the nominal rate minus inflation—is rising. This dynamic is influencing the debate about future policy adjustments.
The monetary policy committee’s 5-4 vote reflected different views about how to manage real interest rates as inflation declines. With the nominal rate at 3.75% and inflation at 3.4%, the current real rate is approximately 0.35%. However, as inflation falls to 2% by spring, the real rate would rise to 1.75% without any nominal rate changes.
Four committee members voting for immediate cuts partly recognized this real rate dynamic. They argued that maintaining a 3.75% nominal rate while inflation falls constitutes a tightening of real policy conditions, which could unnecessarily restrict economic activity. This view suggests nominal rates should fall alongside inflation to maintain appropriate real rates.
Five members voting to hold took a different view, suggesting that rising real rates as inflation falls is appropriate given the need to ensure price stability is sustainable. From this perspective, tighter real conditions help cement low inflation and prevent it from rebounding.
Governor Andrew Bailey’s projection that inflation will fall to around 2% by spring implies a real rate approaching 1.75% if nominal rates stay at 3.75%. The question is whether this level of real interest rate is appropriate for an economy growing at just 0.9% with unemployment reaching 5.3%. Chancellor Rachel Reeves’s budget measures are expected to drive inflation to 2.1% by mid-2026, implying a real rate around 1.65% at that point, well above current levels and potentially quite restrictive for a weak economy.
