It is good to start with some praise for the Bank of England.
After the Halloween budget in Great Britain, and the election night fireworks in the US, the Bank’s Monetary Policy Committee (MPC) helped calm nerves delivering the expected quarter point reduction interest rates to 4.75% on Thursday.
The MPC also indicated that unless there are any new surprises, rates would be reduced “gradually”. This time the Bank’s communication was clear and reassuring.
However, the MPC acknowledged that the economic outlook and path for interest rates were highly uncertain, not least because of the fallout from Rachel Reeves’ first budget.
The Bank’s staff economists echoed the Office for Budget Responsibility in predicting that the additional spending and borrowing in the budget will provide a temporary boost to growth and inflation. This in turn implies that interest rates will remain higher for longer.
So it was some comfort that the Bank still forecast that inflation will return to the 2% target over the medium term – even on market expectations that official interest rates will be ‘gradually’ cut to 2% by the end of next year 3.75%. year.
Besides, that wouldn’t be a bad place to end up. An interest rate of around 4% would be appropriate for an economy growing at 2% and with inflation of 2%.
But there are several ways this soft landing could be disrupted, resulting in much higher interest rates or potentially much lower interest rates.
The immediate threat has already been signaled by the negative reaction to the budget in the bond markets.
The OBR had assumed that official interest rates and bond yields would both be a quarter of a percentage point higher than otherwise over the forecast period as a result of the fiscal measures.
Any impact greater than this – if sustained – would therefore throw public finances off course.
Unfortunately, yields on British government bonds have already risen a lot further. In particular, the OBR forecast that five-year government bond yields would average 3.7% in the fourth quarter of this year, and 4% between 2025 and 2030.
In fact, they have already reached 4.4%.
Investors are not only concerned that the additional spending in the budget will boost inflation and thus slow the pace of interest rate cuts.
They are also concerned that the additional taxes will not raise as much money as expected, and that the additional borrowing will mean that interest rates will have to rise to attract enough buyers for the additional bonds that need to be issued.
In short, there is fear of a lasting “risk premium” for government bonds.
Admittedly, not all of the recent rise in the cost of UK government borrowing is due to events in Britain.
Yields have also risen sharply in the US, partly in anticipation of more fiscal stimulus and higher inflation under a second Trump presidency, given the threat of large unfunded tax cuts and tariff increases.
Other economies whose borrowing costs tend to follow those of the US, notably Australia, have seen similar increases.
Regardless, whatever is behind it, any rate hike will hurt.
The OBR’s arithmetic suggests that even an increase in bond yields, official interest rates and inflation by just half a point could add around £10 billion to the annual cost of debt servicing – potentially requiring further tax rises are to fill the gap.
Sentiment is also important for other markets. It is not widely understood that the current level of official interest rates is often much less important than where they are expected to go in the future.
This is particularly the case for fixed-rate mortgages, where the cost depends on what is expected to happen to the official interest rate over the life of the mortgage, usually the next two or five years.
The problem here is that the mortgage market has already priced in further “gradual” cuts from the Bank of England.
The OBR expects mortgage rates to rise higher from now on, and more than at the time of the March budget.
The result is that borrowing costs in the broader economy may now remain higher for longer, even as the MPC continues to make cuts.
But there is another scenario in which rates could fall even faster than expected – even if it is not attractive.
The increases in taxes and other operating costs in the budget could dampen growth more than boost inflation, meaning rates will have to be cut more aggressively.
Official interest rates are still higher than necessary to keep inflation down, especially given that the full effects of previous increases have yet to materialize, and the Bank is also tightening its policy by reducing its holdings of government bonds. bonds.
The budget has already done that disrupted sentiment among households and businesses – the all-important ‘animal spirits’ – even before the main tax measures come into effect.
Three interim polls (by YouGov, Savanta and BMG Research) showed that many more people expected the total package to be negative for both the economy and their own finances than positive.
Consumer confidence was already wavering in anticipation of a tight budget, but the tax increases were bigger and broader than most expected.
Business expectations for activity in the coming year have softened across the board.
This assessment is of course not necessarily accurate or fair, and it is worth remembering that recent activity data has generally been better than expected, despite weaker confidence.
But there is a real risk that growing concerns about the economic outlook will prove themselves.
The Bank acknowledged the uncertainties on this point, implying that interest rates could still be cut more quickly. But whether interest rates are lower than expected due to a slump in economic activity, or higher due to strong inflation, neither outcome would be much cheering.
Hopefully the MPC will be more agile in the future. But the budget has only made their job even more difficult.
Julian Jessop is an independent economist
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