(Bloomberg) -- Britain’s market upheaval has put the spotlight on its Labour government this week, but economists say the Bank of England will also have to rise to the occasion by slowing interest rate cuts.
While the BOE is not expected to intervene in the market volatility, it may have to demonstrate a renewed commitment to tackle inflation — despite signs of rising unemployment and stagnant growth. It threatens bad news for hundreds of thousands of British homeowners whose mortgage repayments could end up being higher than they were expecting just a few days ago.
“It is going to be increasingly difficult for the bank to have confidence in reducing interest rates further to the extent that the market had previously been pricing,” JP Morgan global economist Nora Szentivanyi said on Bloomberg TV on Thursday. “The wiggle room for the bank is now much narrower, especially if we don’t get further fiscal consolidation.”
Gilt yields have surged and sterling fallen since the start of the year as weak growth and sticky prices rekindle fears of stagflation. Investors have dumped UK assets, wary that inflation has yet to be tamed and the government’s plans to boost GDP will fail to put the national debt on a sustainable setting.
Labour’s £26 billion ($32 billion) budget tax hike on business and rising minimum wage has fanned those flames as companies warn they will pass on the costs. A survey of businesses published by the BOE this week showed that companies plan to lift prices for the coming year by 4%, the highest reading since April.
Furthermore, growing energy and food costs threaten to push inflation even higher. Catherine Mann, the most hawkish of the BOE rate-setters, stressed the UK’s weak supply side during a podcast on Thursday, which makes the economy particularly vulnerable to price pressures.
“The bank hasn’t dealt with inflation yet,” said Fathom Consulting managing director Erik Britton, a former BOE economist. “Inflation has fallen but the second round effects are still in play. Private sector wage growth is unsustainably high, Bond markets are saying that longer-term inflation has slipped from the bank’s grasp. They must address that to restore the credibility of inflation targeting.”
Economic Slowdown
The BOE faces a tricky balancing act as it weighs its inflation fighting credibility against pressure to ease policy fast enough to prevent a sharp economic slowdown. Deputy Governor Sarah Breeden said Thursday that “recent evidence further supports the case to withdraw policy restrictiveness.” Addressing students in Edinburgh, she emphasized weakening activity and the prospect of cooling wage growth.
Households, who have already seen an increase mortgage rates over the past few months, would suffer directly through higher repayments on home loans. “As much as this represents an increase in borrowing costs across the economy, then that is going to have a dampening effect on activity,” said Thomas Pugh, economist at RSM UK. “The most obvious one is that mortgages are priced off the two, three and five-year rates.”
BOE Governor Andrew Bailey signalled last month that four quarter point reductions would be about right for 2025, as policy would remain restrictive at that level. Markets are currently pricing just two cuts, however, to 4.25% by December, and there is some skepticism over the speed of cuts.
Martin Weale, a former BOE ratesetter who is now an economics professor at King’s College London, said policymakers should push back against any expectation of faster rates cuts following the gilt market moves. Two cuts this year remains “sensible”, he told Bloomberg Radio on Friday.
Szentivanyi said she still expects the BOE to cut rates by a quarter point at its meeting on Feb. 6 to 4.5% but is less sure about the rest of the year. Britton predicted a February cut would be “one and done for this year.”
One former BOE official, who would only speak on condition of anonymity, said Threadneedle Street would now be watching financial markets carefully for signs of liquidity strains. If necessary, it could use its emergency tools or even stop selling gilts under its £100 billion a year quantitative tightening program. The BOE said it was monitoring developments as would be expected.
“At some point, you have to acknowledge that the bank hasn’t helped with their rather foolhardy attempt to sell truckloads of gilts into an already oversupplied market,” said Christopher Mahon, a fund manager at Columbia Threadneedle Investments. “Active QT needs to shoulder at least some of the blame.”
--With assistance from Eamon Akil Farhat, Greg Ritchie and Irina Anghel.
(Updates with detail from ninth paragraph.)
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