(Bloomberg) -- The Bank of England has found itself caught in the middle of a trans-Atlantic divide over who will cut interest rates first, with costly implications for gilt traders and British political leaders counting on election year relief from high borrowing costs. 

On one side are City of London economists and BOE Governor Andrew Bailey who say the UK’s outlook seems more like the European Central Bank’s. On the other are investors, who are betting the BOE’s path to rate cuts more closely resembles the Federal Reserve as they rapidly unwind expectations for easing in the US this year. Only one can be right. 

The split has vexed economists, who have seen little in recent UK data to change their mind about the fundamental differences between the British and American outlooks. The UK faces sluggish growth after a shallow contraction in the second half of last year. The US by contrast continues to show strength. 

“Markets have superimposed the US cycle on the UK, but the US and UK are on very different tracks,” said Sanjay Raja, chief UK economist at Deutsche Bank. “The UK is coming out of technical recession. Inflation is falling more convincingly. Pay settlements are following inflation expectations. And crucially, real policy rates in the UK will be higher than in the US.” 

A Bloomberg survey of economists released last week showed that most expected the BOE to make its first quarter-point cut in June, with a full percentage point of easing by year-end. Markets, meanwhile, have gone from pricing in six cuts for 2024 at the start of the year to just two now. At times last week, traders were only fully pricing a single quarter-point cut this year — and then not until November. 

The confusion over when the BOE might begin to climb down from interest rates, which the central bank has kept at a 16-year high since August, is weakening the case for buying gilts in the near term. More broadly, it’s fueling anxieties in the ruling Conservative Party that Prime Minister Rishi Sunak will see little political relief from elevated mortgage rates before he faces Keir Starmer’s resurgent Labour Party in an election later this year. 

The market’s recalibration has accelerated due in part to unexpectedly hot consumer price index data in the US, which has fueled concerns that the Fed faces a difficult “last mile” on the road back to its 2% inflation target. A delayed pivot by Fed Chair Jerome Powell could also prompt other central bankers to slow down, since cutting in isolation risks weakening the local currencies relative to the dollar. 

The UK was swept up into those jitters last week after wage and inflation data came in slightly higher than expected. Inflation fell to its lowest in 2 1/2 years at 3.2% in March, but headline price growth and underlying measures came in slightly above economists’ predictions. Wage growth was also stronger than expected for the three months to February, stubbornly holding at 6%.

The result is that the market’s expectations for BOE easing now looks more like those for the Fed than the ECB. 

“While market expectations for the ECB seem to have decoupled somewhat from their US counterparts, expectations for the BOE continue to track US expectations quite closely,” said Michael Pfister, an analyst at Commerzbank. It’s “likely that the BOE is heading for a small correction in the level of interest rates rather than a pronounced cycle of rate cuts.”

Still, while some economists have since scaled back their predictions for BOE cuts, most haven’t changed expectations for a summer move. Analysts at Morgan Stanley, Goldman Sachs Group, Capital Economics and Bloomberg Economics are all among those still anticipating a shift toward easing in June.

Against that backdrop, Bailey signaled during appearances with his global peers at International Monetary Fund meetings last week in Washington that he thought the UK shared more in common with Europe than America. 

“The dynamics of inflation are rather different between Europe — I mean Europe geographically now — and in the US,” Bailey said on Tuesday. He said the US was experiencing more “demand-led inflation pressure” than in the UK’s stagnant economy, pointing to “strong evidence” of easing price pressures in the latter.

Bailey played down the data on Wednesday, saying the BOE was “pretty much on track to where we thought we would be” as of its February forecasts. The central bank expects inflation to meet its 2% target when April data is released in May, due to another drop in energy bills.

Deputy Governor Dave Ramsden amplified those points on Friday, saying inflation risks are now tilted toward the “downside” and that the UK is looking less like an “outlier” on pricing pressures and more like the euro area.

“We agree with Bailey that the UK’s dynamics look different which provides reason to think the BOE can diverge from the Fed,” said Dan Hanson, chief UK economist at Bloomberg Economics. “We think the market has pushed pricing for the first BOE cut back too far.”

--With assistance from Harumi Ichikura and Philip Aldrick.

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