The Bank of England has decided to cut interest rates. There is ongoing progress in disinflation, though future inflation risks have seen a slight rise for the next 2-3 years.
Current inflation is mainly driven by one-off events. There is a possibility that this could translate into more lasting inflation, although a weaker labour market may counterbalance it.
Sustainability of Rate Cuts
Questions are being raised about the sustainability of recent rate cuts if price and wage-setting behaviours are evolving. The Monetary Policy Committee maintains that UK monetary policy remains restrictive.
In the UK, inflation has not been reduced sustainably, still ranking high among advanced nations. Wage growth continues to impact this, as it remains above pre-pandemic levels.
The focus on wage-setting suggests that wage data will be crucial to economic analysis in the months ahead. There is concern about inflation becoming unanchored, with the potential for a wage-price spiral leading to a hard economic landing.
It is now clear that even though we got an interest rate cut, the path forward is not straightforward. A key policymaker is already highlighting growing inflation risks two to three years out, driven by factors that may be more than temporary. This creates significant uncertainty for the market, which had been expecting a smoother cycle of cuts.
Focus on Wage Data
The main focus for traders in the coming weeks must be UK wage data. We just saw average weekly earnings for the three months to June 2025 remain stubbornly high at 4.9%, a level that clearly makes the Bank of England nervous. If this wage pressure does not cool, the risk of a wage-price spiral becomes very real, which would challenge the case for any further rate reductions.
This concern is amplified by the latest inflation figures, as the headline CPI for July 2025 ticked up to 2.8%, coming in hotter than analysts expected. This is happening even as the labour market shows signs of softening, with the unemployment rate creeping up to 4.5% in the most recent report. This conflicting data between sticky inflation and a weakening job market is creating a difficult balancing act for monetary policy.
For derivative traders, this signals a period of higher interest rate volatility. We believe it is wise to consider buying options that profit from price swings, such as straddles on short-sterling or SONIA futures. Such a strategy would perform well if the Bank is forced to either pause its cutting cycle unexpectedly or even reverse course later on.
The market is already starting to reprice the path for interest rates. Looking at Overnight Index Swaps today, they now imply less than two full 25 basis point cuts by the end of 2025, a notable reduction from the three cuts priced in just last month. This suggests that positions betting on a steep decline in UK rates are now much riskier.
We remember the period of 2022-2023, when central banks were consistently surprised by persistent inflation and were forced to hike rates aggressively. These latest comments indicate the BoE is determined not to repeat that mistake by cutting rates too quickly. Therefore, the threshold for continuing the easing cycle is now considerably higher than it was just a few weeks ago.
