By Andy Bruce
LONDON (Reuters) – Higher inflation fuelled by Britain’s new big-spending budget plans is likely to prevent the Bank of England from cutting interest rates over the next year by as much as investors had expected, further setting it apart from other central banks.
New UK Finance Minister Rachel Reeves announced the biggest tax increases in three decades in her first budget on Wednesday, saying she had to repair the country’s broken public services with heavy spending.
Britain’s independent budget forecaster said her plans would boost the world’s sixth-largest economy in the short run but raise inflation too, adding half a percentage point to the rate of consumer price growth next year.
Even before the budget, investors had singled out Britain as an inflation outlier because of its high rates of wage growth and strong price pressures emanating from the domestic services sector.
The Office for Budget Responsibility (OBR), whose forecasts underpin British government budgets, now expects inflation will average 2.6% next year, compared with a previous 1.5% forecast.
That prompted investors to reel in bets that the BoE will reduce interest rates repeatedly over the next year.
While investors think the central bank is still highly likely to cut Bank Rate on Nov. 7 by a quarter of a percentage point – rate futures were pricing a roughly 85% probability – the budget added to doubt about the outlook for next year.
“Demand and inflation will be higher than expected over the BoE’s two-year forecast horizon, and this will now make it harder for the Bank to deviate from its gradualist mantra on rates,” said J.P. Morgan economist Allan Monks.
Futures markets were pricing roughly four quarter-point cuts from the BoE between now and the end of next year, down from nearly five before the budget.
By comparison, they are pricing almost five cuts from the U.S. Federal Reserve and European Central Bank – both of which have already slashed borrowing costs this year more aggressively than the BoE.
Andrew Goodwin, chief UK economist at consultancy Oxford Economics, said it was unlikely the BoE would have time before next Thursday to fully incorporate the impact of the budget into its new economic forecasts – although it would probably have a rough estimate.
“If the (Monetary Policy Committee) agrees with the OBR’s verdict that GDP growth will be higher next year, this may make it harder to build a narrative that would justify faster rate cuts over the coming year,” Goodwin said.
Gilt prices slumped immediately after the publication of the OBR’s report, which showed Reeves meeting her new fiscal rules by a slim margin, plus higher forecasts for Bank Rate and government bond yields.
“We continue to like gilts. We expect the market to over time shift its attention away from fiscal to the underlying macro drivers, including softening inflation,” said PIMCO economist Peder Beck-Friis.
“Over time, we expect the market to price in a lower terminal rate for the Bank of England’s cutting cycle.”
(Reporting by Andy Bruce; Editing by Jamie Freed)
