The Tide Turns: BoE Rate Cuts on the Horizon as Inflation Forecasts Cool

The Bank of England's May 2025 inflation expectations survey offers a pivotal clue for investors: short-term inflation pressures are easing, while the labor market's softening trajectory is creating conditions for policy easing. With one-year-ahead inflation expectations dipping to 3.2% from 3.4%—the lowest since early 2024—and unemployment rising to 4.5%, the BoE now faces a crossroads. This shift suggests a rate-cut cycle could begin as early as late 2025, favoring UK equities and bond strategies that capitalize on flattening yield curves.

Cooling Near-Term Inflation: A Shift in Sentiment

The May survey reveals a broad-based decline in short-term inflation expectations, with households trimming projections for gas, medical care, and education costs. However, food price expectations rose to 5.5%—a stubborn outlier likely tied to supply chain strains and geopolitical risks.

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This divergence between short- and long-term expectations highlights a key tension. While three-year and five-year inflation forecasts remain elevated at 3.0% and 2.6%, respectively, the BoE's focus on near-term data could prioritize the cooling trajectory. Governor Andrew Bailey's emphasis on a “gradual downward path for rates” signals policymakers are heeding the improved short-term outlook, even as they monitor persistent core inflation (5.5%) and sector-specific pressures.

Labor Market Softening: The Catalyst for Policy Shift

The labor market's slowdown is the linchpin of this narrative. Payroll employment fell by 33,000 in April, marking the largest drop since early 2021, while job vacancies hit a two-year low of 934,000. Wage growth has decelerated to 5.6% year-on-year, with real wages—adjusted for 3.7% CPIH inflation—now growing just 1.8%. This moderation reduces the risk of a wage-price spiral, a key concern during the BoE's 2022–2023 tightening cycle.

The PMI Employment Index's plunge to a 3.5-year low underscores manufacturing and broader sector contractions, driven by rising labor costs and weak demand. With businesses cutting jobs and new orders declining to levels last seen during 2022's market turmoil, the BoE's hands are being forced to ease policy to avoid a sharper slowdown.

BoE Policy: Split Votes, But a Clear Direction

The May MPC meeting's 5–4 vote to cut rates to 4.25%—after holding steady at 4.5% since November 2023—hints at a turning tide. While hawks worry about inflation's 3.5% print (a 15-month high), the consensus now leans toward data-dependent easing. The BoE's May report projects CPI to dip below 3% by Q4 2025, aligning with market pricing for 25–50 basis points of cuts by year-end.

Investment Implications: Position for Easing and Flattening Curves

The setup is ripe for tactical positioning:
1. UK Equities: Cyclical sectors like consumer discretionary (+3.2% YTD in 2025) and financials (+4.1%) could benefit from lower rates and improved business confidence.
2. Gilt Curve Flattening: Expect the gap between short- and long-term yields to narrow as the BoE's easing offsets long-term inflation risks. .
3. Risk Management: Hedge against a potential wage rebound or service-sector inflation spike by underweighting long-dated bonds.

Risks: Long-Term Inflation and Labor Market Overshoots

The divergence between short-term optimism and long-term caution poses the primary risk. If core inflation (5.5%) fails to moderate or wage growth rebounds in sectors like healthcare or tech, the BoE could delay cuts. Additionally, a sharper-than-expected labor market downturn could force deeper easing, disrupting equity valuations.

Conclusion: Easing is Coming—Position Early

The BoE's pivot toward rate cuts is no longer a question of “if” but “when.” With near-term inflation expectations subdued and the labor market softening, investors should favor UK equities and curve-flattening trades ahead of Q4. While long-term inflation and geopolitical risks linger, the data points to a policy shift that could redefine market dynamics in late 2025.

Final Take: Anticipate the BoE's easing cycle by overweighting UK equities and betting on flattening gilt curves. Monitor wage growth and service-sector inflation for potential speedbumps—but bet on the tide turning.