Ever since she delivered her second Budget in November, UK chancellor Rachel Reeves has maintained that cutting the cost of living is her “number one focus”. Bank of England interest rate-setters are paying attention. 

At its latest meeting, the BoE’s Monetary Policy Committee said Budget measures to hold down regulated prices — including for fuel, electricity and rail fares — would cut inflation by 0.5 percentage points in the next few months.

This would help inflation return to the 2 per cent target a year earlier than expected, it added, from 3.4 per cent in December. Inflation data for January will be released on Wednesday.

Some MPC members think these measures could have a more lasting effect — reassuring households that prices will not keep soaring, taking the heat out of pay talks, and ending a wage-price spiral that made the UK’s post-pandemic inflation problem bigger and stickier than in peer countries. 

But other economists are sceptical of governments’ ability, in the UK or elsewhere, to engineer a lasting drop in inflation — unless at exorbitant cost.

Why are some MPC members turning dovish?

Two BoE deputy governors — Sarah Breeden and Dave Ramsden — changed their stance in favour of a rate reduction at this month’s meeting, while external MPC member Catherine Mann said new analysis and developments had “moved the appropriate time for a cut . . . closer”. 

This shift in position hinges on the outlook for wages. 

Ever since inflation started rising in 2021, the BoE’s big worry had been that sticky wage growth would fuel persistently high service price inflation. More recently, policymakers have struggled to understand why employers are still giving relatively generous pay awards, even while cutting jobs.

New analysis by the BoE’s staff gives them some reassurance. 

It suggested that annual wage growth of about 3.25 per cent would be consistent with inflation staying at the 2 per cent target. Private sector wages are still growing faster than that rate, but BoE staff believe there has been no structural change in the way employers set pay. 

They think the overshoot is largely because households now expect inflation to continue running at higher levels than in the past, and are pressing for pay rises to match. 

Central banks would usually “look through” the temporary effect of a freeze on fares or fuel duty, which will fade after a few months.

But in this situation it is possible that a short-term drop in headline inflation, engineered by the government, may lower inflation expectations and take the heat out of wage negotiations, especially when hiring remains so weak. 

Why are MPC hawks more sceptical?

Some BoE policymakers and many economists are sceptical that the Budget measures will really shift households’ expectations of inflation, when it has run above target for so long. 

Huw Pill, BoE chief economist, said last week that after stripping out the effect of Budget measures to curb energy bills, underlying inflation would be at 2.5 per cent in the middle of 2026, rather than 2 per cent.  

While Reeves’ decisions would bring headline inflation down to 2 per cent in the short term, there was “a sort of special measures element of that” and it was an “open question” whether they would have a longer-term effect, he told a City of London audience.

Rob Wood, chief UK economist at consultancy Pantheon Macroeconomics, said it often took “a long period of hitting the inflation target to convince people the target is credible”, adding that most would care more about price levels — which would still be rising — than the rate of change.

“There is some logic to the idea that fiscal policy can affect households’ inflation expectations,” said Michael Saunders, adviser at consultancy Oxford Economics and former MPC member. “The question is how big that impact is . . . I certainly wouldn’t want to rely on it.”

Are there other reasons for strong wage growth?

Key members of the MPC are doubtful the Budget measures will take much pressure off household budgets. They also suspect there is something else going on in the labour market that is keeping wage growth strong, even as unemployment rises. 

Pill spelled this out last week, arguing that the MPC had drawn the wrong conclusions from BoE staff analysis of the way UK employers set wages.

Other rate-setters had drawn comfort from a finding that there had been no structural change in the labour market, he said. But the analysis showed far more employers than previously thought set wages through a bargaining process — whether or not they were unionised.

This helped explain why wage growth had been so persistent over the past few years of high inflation, Pill said, and it might mean that inflation would only stay at target with a higher level of unemployment than in the past.

Combined with other changes that were making the UK labour market less flexible — including on immigration, tax and regulation — rather than worrying less about wage pressures, “we should worry more”, he said. 

Have other governments managed to beat inflation?

The UK government is not alone in seeking to wrestle down inflation. 

Hungary’s Prime Minister Viktor Orbán last year imposed price controls on staple foods from eggs to chicken in an attempt to bear down on the Eurozone’s highest inflation level. In the US, Donald Trump wants to use government-controlled agencies to push down mortgage rates through debt purchases. 

France, which spent 2.5 per cent of GDP on measures to cap gas and electricity prices between 2021 and 2023, now has much lower inflation and wage growth than its Eurozone peers.

The Banque de France believes the policy has given French industry a new competitive edge because labour costs have fallen relative to Germany’s by as much as 10 per cent. 

But France’s fiscal intervention was on a far bigger scale than that set out by Reeves — and it was more powerful because the country’s minimum wage is indexed to inflation. 

Even so, as the Banque de France concluded in a 2024 evaluation of the “tariff shield”, the government could only ever subsidise prices to that extent temporarily. 

In any lasting shock, the policy “would only delay the rise in inflation, unless it were maintained indefinitely, at a prohibitive budgetary cost”, it added.