Bank of England, Inflation and the UK Equity Risk Premium
When the Bank of England cut rates back down to 3.75% in December 2025, it felt like a turning point after two brutal years of tightening. Yet by March 2026, gilt yields were spiking again and traders were quietly ripping up their neat rate‑cut calendars. The message from Threadneedle Street is simple: the inflation fight is not quite over, and that matters directly for how UK risk assets are priced.
The BoE’s own explainer notes that Bank Rate has been lowered “several times” from its peak, with the most recent move taking it to 3.75% as inflation cooled from double digits to 3.4% at the end of 2025. At that point, markets were fully pricing an additional 25‑basis‑point cut by February 2026 and roughly 66 basis points of easing by the end of 2026, equivalent to almost three quarter‑point cuts. But a combination of stickier‑than‑expected services inflation and fresh energy‑price worries has since complicated that path. The BoE now projects CPI at about 3% in Q2 2026, up from a previous forecast of 2.1%, and has warned of “upside risks” if oil and gas stay elevated.
Gilt markets have responded quickly. In early March, five‑year yields jumped around 19 basis points, ten‑year yields about 14 bps, and two‑year yields 12 bps in a single session, unwinding part of the earlier rally that had brought borrowing costs down. Goldman Sachs describes UK yields as “unusually high” for an economy with modest growth, attributing much of the premium to fiscal concerns and lingering inflation risk, not just global rate levels.
For UK equities, this combination pushes the equity risk premium into focus. On one side of the ledger, the FTSE 100 still offers a forward dividend yield around 3.3–3.4%, with total 2026 dividends expected to reach a record £88 billion. On the other, ten‑year gilts trade in the 4–4.5% range, offering a risk‑free income stream that looks competitive with equity yields. That narrows the classic “excess yield” investors earn for owning stocks over government bonds, especially when UK banks and insurers are also issuing high-coupon credit.
In this environment, the BoE’s path matters less as a binary “cut vs no cut” and more as a signal about how long real yields will stay restrictive. A slower easing cycle that keeps gilts near current levels forces equity investors to demand either higher earnings growth or lower entry valuations to justify UK stock risk, particularly in domestically exposed sectors. Conversely, a clearer glide‑path back towards 3.25% by late‑2026, of the sort some sell‑side houses still forecast, would support the case that today’s earnings yields and dividends offer a more generous risk premium than headline gilt rates alone suggest.
For now, the equity side of the ledger has held up: UK large caps have outperformed domestic macro data, helped by foreign earnings and sector mix. Whether that continues will depend heavily on whether the BoE can bring inflation back to target without keeping real yields high enough to choke off growth — the outcome that will ultimately calibrate how much extra return investors insist on from UK stocks versus gilts.