Higher inflation, fueled by Britain’s new high-spending budget plans, is likely to prevent the Bank of England from cutting interest rates next year as much as investors had expected.
Britain’s new finance minister Rachel Reeves announced the biggest tax rises in three decades in her first budget on Wednesday and said she needed to fix the country’s broken, high-spending public services.
Britain’s independent budget forecaster said their plans would boost the world’s sixth-largest economy in the short term but would also increase inflation by increasing the growth rate of consumer prices by half a percentage point next year.
Even before the budget, investors had labeled Britain an inflation outlier due to high wage growth and strong price pressures coming from the domestic services sector.
The Office for Budget Responsibility (OBR), whose forecasts underpin Britain’s budget, now expects inflation to average 2.6% next year, compared with a previous forecast of 1.5%.
That prompted investors to scale back their bets that the BoE will cut interest rates repeatedly over the next year.
Even as investors continue to expect the central bank to cut interest rates by a quarter of a percentage point on November 7 with a high probability – interest rate futures put the probability at about 85% – the Budget has deepened doubts about the outlook for next year .
“Demand and inflation will be higher than expected over the BoE’s two-year forecast horizon and that will now make it harder for the bank to deviate from its gradual mantra on interest rates,” said Allan Monks, economist at JP Morgan.
Futures markets were expecting around four quarter-point interest rate cuts from the BoE by the end of next year, up from almost five before the budget.
By comparison, they expect nearly five interest rate cuts from the U.S. Federal Reserve and the European Central Bank – both of which have already cut borrowing costs more aggressively than the BoE this year.
Andrew Goodwin, chief UK economist at consultancy Oxford Economics, said it was unlikely the BoE would have time to fully incorporate the impact of the budget into its new economic forecasts before next Thursday – although it would likely have a rough estimate.
“If the (Monetary Policy Committee) agrees with the OBR’s assessment that GDP growth will be higher next year, it could become harder to build a narrative that would justify faster rate cuts next year,” Goodwin said.
In the immediate aftermath of the release of the OBR report showing that Reeves was narrowly complying with her new budget rules, as well as higher forecasts for the key interest rate and government bond yields, government bond prices collapsed.
“We remain committed to gilts. We expect that over time the market will shift its attention from fiscal factors to underlying macroeconomic factors, including easing inflation,” said PIMCO economist Peder Beck-Friis.
“We expect the market to price in a lower final rate for the Bank of England’s rate cutting cycle over time.
