“Reading the tea leaves” - where is inflation and monetary policy headed next?

Henrik Helsen
4 days ago
4 min read

Central banks have had a torrid time since the start of the COVID-19 pandemic. As economies reopened after the initial shock, gummed-up supply chains and a burst of pent-up demand pushed inflation steadily higher. At first, many central banks - including the Federal Reserve and the Bank of England - described these price rises as “transitory”. This proved optimistic, to say the least. What followed was a cycle of aggressive monetary tightening to curb the inflationary spike felt across most of 2022 and 2023. The UK benchmark rate eventually rose to 5.25% - a level not seen since before the 2008 financial crisis.

Initially, it appeared that central bank policy had done its job. Inflation fell sharply from double-digit highs by early 2023, and the UK avoided the recession that often accompanies monetary contractions. In other words, the economy seemed on course for the coveted “soft landing”. Since mid-2024, however, inflation has proved surprisingly stubborn. After briefly falling to 2.6% year-on-year in September 2024, CPIH inflation climbed back to 4% by mid-2025. Although inflation is now falling again - and the Bank of England expects a return to target within the next two years, potentially signalling further cuts - structural changes in the UK economy mean that a return, even a gradual one, to the easy money of the 2010s is unlikely.

This article takes a deeper look at where UK monetary policy might be headed over the next few years. Policymakers use several tools to guide interest rate decisions. Undergraduate economists will be familiar with the Taylor rule, which states that the policy interest rate (i*) should reflect current inflation, target inflation, and the “output gap” - how far away the economy is from full capacity. But the Taylor rule treats the policy rate as a transformation of a deeper variable: r*, the neutral rate.

So what exactly is r*, how does it work, and why does it matter? r* is the theoretical neutral interest rate that keeps inflation at its 2% target while maintaining an output gap of zero — meaning the economy is operating at full capacity. Crucially, r* is not directly observable. Instead, it helps central banks judge whether the actual policy rate is restrictive (i* > r*) or accommodative (i* < r*). For example, if a country’s r* is 2%, then a policy rate of 4% is as restrictive as a rate of 6% in a country where r* is 4%.

One might expect r* to remain fairly constant over time, since it is conceptually separate from short-term price movements. However, evidence suggests that r* has risen by 25–75 basis points since 2018. Several structural factors underpin this shift. Rising sovereign debt has increased the government’s demand for loanable funds, pushing up the market-clearing interest rate as it competes with private borrowers. Higher public borrowing can also raise perceived default risk, prompting investors to demand a higher risk premium. This, too, feeds into estimates of r*. In addition, domestic and global savings rates have fallen over the past decade as older generations have moved into retirement, further pushing upward on the neutral rate as fewer loanable funds are available to support desired investment.

The implication is straightforward: if r* has risen, then interest rates must stay higher for longer to keep inflation on target. Yet the Bank of England also has a dual mandate. It must support employment as well as price stability. UK unemployment has begun to tick up, reaching 5% in the three months to September (up from 4.3% a year earlier). A similar problem has intensified in the United States, though political pressures on the Federal Reserve - combined with President Trump’s impending appointment of a new chair - suggest that US rates may lean more accommodative to support job growth ahead of the 2026 election.

Since the financial crisis, it has typically been clear which objective - employment or inflation - required the most attention. Today, the Bank of England faces the unusual and unwelcome task of navigating a genuine trade-off between the two. Markets strongly expect a 25-basis-point cut to 3.75% at the upcoming meeting, following recent inflation data and the latest Budget. Beyond that, however, the outlook is highly uncertain. The prevailing expectation of two further cuts in 2026 is coloured by a substantial degree of doubt.

Over the next year, the picture should become clearer. If food and drink inflation - typically volatile because of supply shocks - falls from its currently elevated level, overall inflation could drop substantially. Combined with a continued rise in unemployment, this would strongly signal that monetary policy is too restrictive. Even if inflation remains above target, the Monetary Policy Committee may still choose to ease policy if it judges that inflationary pressures will not re-accelerate. Monetary policy is, after all, as much an art as a science. Whatever happens, the Bank of England faces some difficult decisions ahead.

The views and opinions expressed in this article belong solely to the writer and do not necessarily reflect the views and opinions of the Warwick Economics Summit.

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