Bank of England’s hawkish budget turn may not succeed

The UK’s key tax, borrowing and investment budget extended the Bank of England’s (BoE) interest rate horizon, but sterling fluctuated and reversed, suggesting some believe the BoE may well take a more nuanced view of the year ahead.

Bank of England officials are currently in their traditional period of silence ahead of Thursday’s interest rate decision, so the central bank did not immediately respond to the budget.

But markets have already adjusted their forecasts after reading the rungs of the UK’s budget plans and revised forecasts from the independent Office for Budget Responsibility (OBR), which show higher growth and inflation next year.

Not only are markets now forecasting that the UK will see at least one smaller rate cut than before next year, but it has even raised some doubts about whether there will be any easing this week.

Until last Wednesday, money markets were confident that the Bank of England would announce its second rate cut this year by 25 basis points, cutting the policy rate to 4.75%.

The likelihood of this happening has since dropped to 80%. And Goldman Sachs is breaking with the pack and now predicts that the bank will abstain from Thursday’s meeting.

Moreover, implied market rates at year-end 2025 have risen to more than 4%. That’s now half a point higher than the Fed equivalent for the year, although the difference between the two is now just over 10 bps. Five-year government bond yields are also higher than US Treasury yields – despite a sharp pre-election rise in the US. And five-year bonds are about two percentage points ahead of German benchmarks.

An 18 bp increase in two-year bond yields. on Thursday was the biggest one-day change since February.

While this may indicate that markets are bracing for more major UK borrowing, market pressure to revise the Bank of England’s rate forecast appears less clear.

While it is difficult to predict movements in the global bond market ahead of a potentially seismic US presidential election, the sterling’s harsh reaction to this week’s major changes to UK fiscal policy is notable.

Sterling was little changed on Budget Day and has actually weakened against both the dollar and the euro since then. This reflects either a resurgence in the UK risk premium or casts doubt on whether the Bank of England will actually deliver on the markets’ more hawkish interest rate forecasts.

Take a risk or rethink

Arguments for a more aggressive Bank of England policy focus on introducing new stimulus into the economy and forecasts for higher inflation. The latter are fueled by parallel increases in the UK minimum wage and the risk that employers, bearing the brunt of new tax rises, may try to recoup lost revenue by raising prices.

With the Bank of England still wary of rapid rises in wages and service prices, even as headline inflation has returned to target, many now believe Governor Andrew Bailey’s recent proposal for more “aggressive” monetary easing. may have to be postponed.

But the Bank of England has good reason to stay the course.

The OBR’s new inflation forecast for next year of 2.6% is just a tenth or two higher than the Bank of England’s standing forecast from its August monetary policy report, which will be updated this week.

Additionally, the bank may be looking at the potential impact of fiscal measures over the longer term, which may prevent them from overreacting.

In its budget review, the independent think tank National Institute of Economic and Social Research said the increase in employers’ payroll taxes would hit job creation over time and would likely push up the unemployment rate.

“We expect significant negative impacts on employment and wage growth, particularly in low-wage sectors such as hospitality,” it said of the combined tax and minimum wage increases.

While the OBR forecasts real gross domestic product growth in the UK to be 2% next year, it expects the figure to decline after that, returning to 1.8% in 2026 and back to 1.5% in subsequent years. In such an environment, the government may find it difficult to finance increased borrowing unless interest rates fall sharply.

So the Bank of England’s hawkish turn may not be as obvious as many assume – unless, of course, the pound actually gets seriously scared and complicates the whole picture even more. — Reuters

Mike Dolan writes for Reuters. The opinions expressed here are those of the author.