Bank of England "Turns Dovish": Allowing Inflation to Temporarily Overshoot Target, Signaling Reduced Probability of June Rate Hike

Bank of England Governor Bailey released a clearly dovish signal, stating that against the backdrop of a weak economy, the central bank can tolerate inflation running above the 2% target for a period — a statement that significantly cooled market expectations for a June rate hike.

On May 29, Bailey spoke at an economic conference in Reykjavik, Iceland, explicitly stating that "tolerating inflation temporarily above target to support the real economy, against a backdrop of a weak real economy and uncertainty about the scale and duration of the shock, is the appropriate way to handle this trade-off." However, he warned 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 June 18 meeting. Market reactions adjusted accordingly — the interest rate swap market currently prices in only one 25-basis-point rate hike by the end of 2026, whereas as recently as late April, markets had expected three rate hikes this year.

The surge in energy prices triggered by Middle East tensions has put the UK at risk of a second cost-of-living crisis in less than five years. Bailey's speech indicated that the Bank of England is prioritizing the prevention of further economic deterioration, but the high uncertainty surrounding the inflation outlook continues to keep policymakers treading carefully.

Removal of Interest Rate Cut Expectations Has Constituted Substantive Tightening

Bailey stated that by abandoning the previously market-expected path of interest rate cuts, the Bank of England has effectively tightened policy to a considerable degree.

Before the US and Israeli attack on Iran in late February, investors had expected the Bank of England to cut interest rates by 50 basis points this year in two moves. After the conflict broke out, expectations reversed to rate hikes of an equivalent magnitude. This shift in expectations drove a sharp climb in UK gilt yields, which in turn raised borrowing costs for households and enterprises.

"By taking the expected rate cuts off the table, we have significantly tightened policy relative to market expectations, and that is already having an impact on the economy," Bailey said. This means that even if the central bank holds rates steady, the substantive tightening of financial conditions is already working to cool inflation, providing a rationale for standing pat.

Economy Under Pressure: Consumption and Investment Both Contract Amid Energy Shock

The rise in energy prices stemming from the Middle East conflict is dragging on the UK economy across multiple dimensions. The latest data showed that consumer spending declined, enterprises delayed investment, accumulated inventory, and cut staff, with high energy costs and domestic political uncertainty compounding each other, notably weakening economic momentum.

Purchasing managers' survey data also corroborated this trend — surveys released this month showed that business activity slowed sharply after a strong start to the year. Meanwhile, the labour market continued to loosen, with Bailey stating during the Q&A session that "the picture of a gradual softening in the labour market is coming through quite consistently."

UK inflation fell to 2.8% in April from 3.3% in March, but analysts noted that this was largely attributable to one-off measures announced by the government in November, and the Bank of England expects inflation to rebound in the coming months.

Second-Round Effects: The Core Variable in the Policy Dilemma

Although Bailey leaned toward keeping rates stable, he remained highly vigilant about the risk of second-round effects — where energy price shocks trigger significant wage increases, which in turn drive enterprises to raise prices again, creating an inflationary spiral.

Bailey acknowledged that there were divisions within the Monetary Policy Committee on this issue. Some members worried that UK wage growth next year could be too rapid, while more dovish colleagues argued that rising unemployment would suppress this risk. Bailey noted that since most wage agreements this year were negotiated before the conflict broke out, the wage data available to the central bank in the coming months would be very limited, potentially leading to a situation where inflation expectations rise without a corresponding acceleration in wage growth.

He also cited the lesson from four years ago as a warning — when inflation triggered by the Russia-Ukraine conflict once surged to double digits. "Because second-round effects take longer to transmit, the case for looking through indirect effects is actually weaker; if indirect effects persist for too long, unless monetary policy responds in a timely manner, inflation will remain above target for an extended period," Bailey said.

Market Reaction: Rate Hike Expectations Cooled Significantly

Throughout May, market expectations for Bank of England rate hikes declined substantially. The interest rate swap market currently prices in only one 25-basis-point rate hike by the end of 2026, a notable shift compared with the three rate hikes expected in late April.

Initial market reaction following Bailey's speech was mediocre. He was subsequently set to be interviewed by Stephanie Flanders, Bloomberg's Editor-in-Chief for Economics and Government Affairs, which may provide further policy clues.

The Monetary Policy Committee meeting on June 18 will be the next important period. Bailey's remarks provided a fairly clear signal for holding rates steady, but the evolution of the inflation outlook — particularly energy price trends and wage data — will remain the key variables determining the policy direction.