Bank of England Governor Andrew Bailey delivered distinctly dovish signals, indicating the central bank can tolerate inflation running above its 2% target for a period amidst a weak economic backdrop—a stance that has significantly dampened market expectations for a June rate hike. On May 29, speaking at an economic conference in Reykjavík, Iceland, Bailey explicitly stated, "In the context of weakness in the real economy and uncertainty about the scale and duration of the shocks, tolerating a temporary period of inflation above target to support the real economy is the right way to manage this trade-off." However, he also cautioned that this tolerance would diminish should signs of second-round effects emerge. The above remarks suggest Bailey is unlikely to support a rate hike at the Monetary Policy Committee's meeting on June 18. Market pricing has adjusted accordingly—interest rate swap markets now price in only one 25-basis-point hike by the end of 2026, a stark contrast to late April when three hikes were anticipated for this year. Soaring energy prices due to Middle East tensions risk plunging the UK into its second cost-of-living crisis in less than five years. Bailey's speech indicates the Bank of England is prioritizing preventing a further economic downturn, though policymakers remain on edge due to the high uncertainty surrounding the inflation outlook.
Removing Rate Cut Expectations Constitutes Substantial Tightening
Bailey stated that by abandoning the market's previously expected path of rate cuts, the Bank of England has already implemented a significant degree of policy tightening. Prior to the US and Israeli strikes against Iran in late February, investors had expected the Bank of England to cut rates by 50 basis points this year, implemented in two steps. Following the outbreak of conflict, expectations reversed to an equivalent magnitude of hikes. This shift in expectations drove UK government bond yields sharply higher, thereby increasing borrowing costs for households and businesses. "By taking the expected rate cuts off the table, we have tightened policy substantially relative to market expectations, and that is already affecting the economy," Bailey said. This implies that even if the central bank holds rates steady, a substantive tightening of financial conditions is already at work cooling inflation, providing justification for inaction.
Economic Pressure: Consumption and Investment Contract Under Energy Shock
Rising energy prices stemming from Middle East conflict are weighing on the UK economy from multiple angles. Recent data shows reduced consumer spending, businesses delaying investment, accumulating inventory, and cutting staff. High energy costs combined with domestic political uncertainty are clearly weakening economic momentum. Purchasing Managers' Index survey data corroborates this trend—surveys released this month show business activity has slowed sharply after a strong start to the year. Meanwhile, the labor market continues to loosen. Bailey noted during a Q&A session, "The picture of gradual softening in the labor market is coming through quite consistently." UK inflation fell to 2.8% in April from 3.3% in March, but analysts point out this largely stems from one-off measures announced by the government in November. The Bank of England expects the inflation rate to rise again in the coming months.
Second-Round Effects: The Core Variable in the Policy Dilemma
Despite Bailey's leaning towards keeping rates steady, he remains highly vigilant about the risk of second-round effects. These refer to energy price shocks triggering significant wage increases, which in turn push firms to raise prices again, creating an inflationary spiral. Bailey acknowledged divisions within the Monetary Policy Committee on this issue. Some members are concerned about excessively strong UK wage growth next year, while more dovish colleagues believe rising unemployment will contain this risk. Bailey pointed out that as most wage agreements for this year were settled before the conflict erupted, the central bank will have very limited wage data to assess in the coming months. This could lead to a scenario where inflation expectations rise without a corresponding acceleration in wage growth. He also issued a warning, drawing on lessons from four years ago when inflation triggered by the Russia-Ukraine conflict once soared into double digits. "The case for looking through indirect effects is weaker because second-round effects take longer to come through; if indirect effects persist for too long, inflation will be above target for a prolonged period unless monetary policy responds in a timely manner," Bailey said.
Market Reaction: Rate Hike Expectations Cool Significantly
Throughout May, market expectations for a Bank of England rate hike have declined substantially. Interest rate swap markets now price in only one 25-basis-point hike by the end of 2026, a marked shift from the three hikes anticipated in late April. Initial market reaction following Bailey's speech was muted. He is subsequently scheduled for an interview, which may provide further policy clues. The Monetary Policy Committee meeting on June 18 will be the next key milestone. Bailey's remarks provide a relatively clear signal in favor of holding rates steady, but the evolution of the inflation outlook—particularly energy price trends and wage data—will remain the critical variables determining the policy path.
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