Interest rates likely to remain higher for longer
Markets are indicating interest rates are set to stay higher for longer than expected after the Bank of England’s “hawkish cut” and gloomy inflation and growth forecasts shocked City analysts.
Prior to the Bank’s interest rate cuts, markets had all but priced in a further 25 basis point cut by the end of the year, which would bring borrowing costs down to the lowest level since 2022.
But the minutes from the latest Monetary Policy Committee (MPC) meeting showed hawks becoming more worried about food price inflation. Markets reacted by repricing the risk of further cuts during the rest of the year. Traders now believe there’s only a 50 per cent chance of a cut in November.
UBS economist Anna Titareva said the MPC’s assumptions of high inflation affecting the path of interest rates were “striking”.
Analysts at Capital Economics and Oxford Economics were among those who said they were “less confident” of another rate cut taking place in November to get interest rates down to 3.75 per cent.
“If inflation continues to surprise to the upside, this could tip the balance towards no change, particularly if market pricing moves against a rate cut,” said Oxford Economics’ Andrew Goodwin.
“With Governor Andrew Bailey now clearly the committee’s swing voter, his comments will also prove key.”
Interest rates set to generate a headache for Rachel Reeves
Rachel Reeves has praised successive interest rate cuts over the last year, claiming they would help mortgage holders and allow businesses to borrow more for growth.
Lower rates could also boost UK growth, which has slowed this year. The economy has experienced two consecutive contractions in April and May, according to the Office for National Statistics (ONS).
But more pertinently to public finances, lower interest rates can help to ease borrowing costs for Reeves while the Office for Budget Responsibility (OBR)’s own forecasts hinge on market predictions on monetary policy.
In a press conference on Thursday, Bailey declined to comment on how the Bank would react to further tax rises, with the Bank claiming that last year’s Autumn Budget dampened UK GDP.
The National Institute of Economic and Social Research (NIESR) suggested the government faced a £50bn black hole in public finances, while The Guardian reported on Friday that Rachel Reeves and Keir Starmer would hold meetings on possible tax hikes.
Sandra Horsfield, senior financial markets economist, said “discussions behind closed doors” would have likely considered the consequences of the OBR downgrading productivity forecasts, which would cost the government billions of pounds.
AJ Bell’s head of investment analysis Laith Khalaf said there was little chance of Reeves seeing the “windfall” of a surprise interest rate cut at the next decision in September.
Khalaf also said “pensioners have something to cheer” about after the Bank revised its inflation forecast for September up to four per cent.
The triple lock on the state pension, which means it increases each year by whichever is highest out of inflation or wage growth in September, could lead to an addition of around £478 to annual payments and cost Reeves billions of pounds more than expected.
“It’s possible that wage growth may trump inflation, and pensioners get an even bigger bump in their income,” Khalaf said.
“But if the Bank of England is right about inflation, then pensioners can look forward to a rise of at least four per cent in their state pension next year.
“No doubt this will once again raise questions about the fairness of the triple lock, especially against a fiscal backdrop which suggests the chancellor is going to have to stick a shovel into taxpayers’ pockets again in the autumn Budget.”