Key Takeaways:
Bank of England Governor Andrew Bailey said the central bank can tolerate inflation temporarily above its 2% target, sharply reducing the probability of a June rate increase.
Bank of England Governor Andrew Bailey said the central bank can tolerate inflation temporarily above its 2% target because of weak domestic demand, effectively removing a June rate increase from the table and pushing gilt yields lower. The remarks at the Reykjavik Economic Conference on Friday represent Bailey's most dovish language since the Iran conflict closed the Strait of Hormuz shipping lane in late February.
"In the context of weak real activity and uncertainty about the size and persistence of the shock, tolerating inflation above target for a time to support the real economy is the appropriate way to manage this trade-off," Bailey said. He warned that tolerance would diminish if second-round effects — where energy price increases feed into wage bargaining and push up prices further — begin to materialize.
The shift in messaging has already tightened financial conditions by removing the three quarter-point cuts markets had priced for 2026 before the Iran conflict erupted. Rate swaps now imply just one 25-basis-point increase by year-end, down from three hikes expected in late April. The 2-year gilt yield fell 8 basis points on the remarks while GBP/USD slipped 0.3% to 1.3447, testing its 200-day exponential moving average at 1.34. Brent crude, which peaked above $138 a barrel in April during the worst of the energy shock, has since collapsed to about $99 as a U.S.-Iran ceasefire framework took shape.
The dovish pivot puts the BoE at odds with the Federal Reserve under new Chair Kevin Warsh, where markets price an 80% probability of a December rate increase. With the UK Bank Rate at 3.75% and the fed funds rate at 3.50% to 3.75%, any divergence in policy paths would widen the rate differential against sterling, potentially pushing GBP/USD toward the 1.33 support level. The last time the BoE and Fed diverged on policy direction was in the second half of 2024, when the BoE cut rates from 5.25% while the Fed held steady, sending cable from 1.30 to 1.25 over three months.
Inflation and the labor market trade-off
UK consumer price inflation rose to 3.3% in March from 3% in February, well above the BoE's 2% target, before easing to 2.8% in April on a one-off government measure. Services inflation, the stickiest component and the one most resistant to monetary tightening, stood at 4.5% in March. Bailey argued that continued weakness in the labor market — unemployment has risen to 5% while job vacancies hit a five-year low — lessens the risk that higher energy costs will embed into wage demands.
"Continued weakness in UK activity and the labor market is likely to lessen the strength of second-round effects from higher energy prices," Bailey said, while acknowledging that those effects would be stronger the more persistent the energy price rise. The International Monetary Fund recently downgraded its UK growth forecast for 2026 to 0.7% from 1.2%, the largest single-country revision in its updated outlook.
The June 18 decision and the path ahead
The Monetary Policy Committee's next meeting on June 18 will be the first test of Bailey's new framework. Markets now assign a low probability to a rate increase, a sharp reversal from April when three consecutive hikes were fully priced. The MPC has held the Bank Rate at 3.75% since December 2025, when it delivered the last cut of the easing cycle that began in August 2024 from a peak of 5.25%.
Bailey noted that the BoE has already tightened policy "considerably" relative to market expectations by removing the prospect of rate cuts, and that this has forced lenders to reprice mortgages and corporate loans. Key quoted rates on mortgages have increased since the onset of the conflict, he said, even with the Bank Rate unchanged. The question for the June meeting is whether the MPC's hawks — who have warned that wage growth expectations in the 3.5% to 4% range are inconsistent with the 2% inflation target — will accept Bailey's tolerance framework or push for a preemptive hike to contain second-round effects before they become embedded.
This article is for informational purposes only and does not constitute investment advice.
