Budgeting is not a big deal with interest rates
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For one hour on Wednesday, the financial markets’ reaction to Rachel Reeves’ Budget was dire – even Truss-like. Between 2pm when the prime minister finished his speech and 3pm, the UK government’s borrowing costs rose by 0.2 percentage points, whether they wanted to borrow short-term or long-term term.
This is a much higher rise in yields than comparable government bond markets on both sides of the Atlantic and Treasuries must be worried. Things weren’t much better on Thursday. If financial markets cause major trouble for the Budget for the second time in just over two years, it will be a significant blow to both households and the Treasury.
However, there are important differences with Liz Truss’s “small” Budget debacle. First, the UK market was calm. Second, the initial increase in borrowing costs was not accompanied by a fall in the value of the pound. Compared to 2022, foreigners have not dumped UK assets.
The market reaction appears to follow the Office for Budget Responsibility new forecast This suggests that higher public spending will further increase demand and inflation, while increased taxes will affect supply.
This all sounds quite inflationary and the financial watchdog said that while it still expects the Bank of England’s policy rate to fall, the Budget measures will see interest rates higher 0.25 percentage points compared to the assumptions when initially making the forecast. More spending, more borrowing and higher taxes mean higher interest rates.
This is reasonable analysis from the OBR, which is making a comparison based solely on the current outlook versus the outlook in March. But it makes little sense for the BoE to follow suit.
The central bank has had plenty of time to adjust its thinking to Reeves’s views. announced July 29 that public spending will be much higher than the OBR assumed in March. Besides public finance data that also shows huge overspending, the Budget cannot come as much of a surprise.
The key question for the BoE’s Monetary Policy Committee is which news is authentic. This is quite limited. The increase in public borrowing in 2024-25 caused directly by policy decisions is £23.7bn, only slightly higher than the chancellor’s announcement of a £22bn black hole in July .
Whatever you think about the veracity of Reeves’ numbers, during meetings in August and September, MPC members knew that this fiscal stimulus was coming. They didn’t think it had important implications for interest rates then. If the BoE says next week that its November meeting is the first time it will consider the impact of Labour’s fiscal plans and that these are more inflationary, it will reflect very Poor BoE’s ability to respond to events. For that reason, I think that possibility is very unlikely.
It’s also worth noting that the BoE has traditionally been averse to suggesting it is responding to loose fiscal policy with higher interest rates. When former prime minister Jeremy Hunt cut national insurance at the end of 2023 And early 2024Its response was a big shrug.
Based on information we have had for some time, UK fiscal policy is easing slightly this year but is on the path to medium-term tightening, inflation threats have reduced significantly and Wage pressure is easing.
This is still a condition for the BoE to lower official interest rates at a pace determined by greater uncertainties than UK fiscal policy. Already suffering from a longer-lasting inflation shock than other European countries, especially in the service sector, the central bank needs to maintain tight monetary policy. But it can do so while cutting interest rates gradually.
The budget is unlikely to change this reality much. The tax increase is huge. Larger increases in spending. But the overall macroeconomic balance did not change much on Wednesday.
