This week saw the Bank of England’s Monetary Policy Committee (MPC) vote 5-4 to cut interest rates from 5.25% to 5%. This cut was fully justified in the face of recent inflation data. As the Governor stated at the press conference, monetary policy is still in restrictive territory. In particular, he cited that growth is below potential and that interest rates are above neutral, although he did not clarify where he sees this as being.
There was a significant change in language from the Bank, with it now talking of persistence in terms of inflation. Also, another change was that, in response to the Bernanke review which outlined major faults in their approach to setting policy, the Bank has “repositioned today” (to use the words of the Governor) to now have a “framework on policy that sits above the data”.
Even though we have always known that monetary policy acts with a lag, the Bank will now not just set policy based on the data, but also in terms of that framework. This contains three scenarios of the inflation outlook, two of which were benign where inflation returns to target. Perhaps the message might be that while rates will fall, this new framework suggests the MPC may not cut rates quickly or sizeably.
While the Bank has been forced to revise up their view for growth this year to 1.25%, they remain pessimistic about the economy’s growth prospects, seeing underlying growth of only 0.3% per quarter, far lower than its current pace.
Ideally there should be consistency between monetary and fiscal policy. But if we move to a tight fiscal policy – as seems possible – this will add to the pressure for further UK rate cuts. This week also saw the Chancellor’s Statement to the House of Commons. The public finances are not in great shape, a legacy of the pandemic and policy decisions. In June the ratio of debt to GDP was 99.3%. This may be the second lowest in the G7 but it is high.
The Chancellor announced the results from the audit that she had commissioned of the public finances. In doing so, one might well ask whether Reeves is adopting OsBrown economics – a combination of Osborne and Brown when each entered Number 11.
When he became Chancellor in 2010, Osborne blamed the previous government for the position of the public finances and then announced tough policy decisions. That worked for the first two years – as it was accepted that spending needed to be more disciplined – but by 2012 it was clear that the austerity being pursued was inappropriate, as I argued at the time.
Indeed, the UK had the opportunity then to lock into long-term borrowing rates to fund necessary infrastructure spending, which it didn’t take. That same opportunity resurfaced in 2019 and we failed to seize it then, either.
With Reeves there are also elements of Gordon Brown in 1997. He stuck to the very tough fiscal rules that he inherited, so much so that the UK ran three successive years of budget surpluses before policy was eased significantly. There is little doubt that Reeves is aiming to establish her fiscal credibility by being seen as a tough Chancellor.
There are various ways to reduce this debt ratio including a combination of economic growth, reform of public finances, austerity in terms of keeping spending under control, tax and borrowing. While growth is best, the economic context should drive the policy choices.
The economic message from the Statement was aimed at showing she was fiscally responsible in the face of what she claimed was a poor inheritance. Yet the economy is rebounding solidly. The Budget has been set for October 30th and the expectation is this will be a tough Budget, with tax increases as well as further borrowing.
The Chancellor’s message was that the audit had uncovered a £21.9 billion fiscal gap not covered by existing figures. This was explained by four factors: unfunded spending plans; higher inflation; recent events such as Ukraine; and public sector pay awards.
Given this, the Chancellor announced an immediate fiscal tightening relative to plans of £5.45 billion for 2024/25 and £8.15 billion for 2025/26. This included ending the winter fuel allowance for the vast bulk of pensioners, saving £1.5 billion, plus cancelling a number of infrastructure plans linked to road and rail, claiming that money had not been allocated for these.
The bulk of the overshoot is explained by the pay awards the Chancellor herself decided to grant, and by the higher-than-expected asylum costs – although the fact that the contingency reserve of £8.6 billion had already been used up so early in the fiscal year probably is indicative of the upward pressure on public spending.
To put £21.9 billion in context, it compares with a budget deficit of £49.8 billion in the first three months of this fiscal year and with government spending – or total managed expenditure – of £1,226.3 billion for 2024/25 that was outlined in the Budget.
A core problem is that the last Spending Review was in 2021 and since then inflation has soared, plus there have been policy commitments that the Chancellor referred to and which have not been fully funded. Importantly, the Chancellor has announced a new, future and welcome two-year spending cycle.
In terms of the immediate outlook, though, the picture points to a tough October Budget. While stronger growth this year will ease some of the pressure (growth in 2024 may be closer to 1.2% and the OBR had factored in 0.8%), the previous spending plans had always looked implausible, as was widely acknowledged. There is already upward pressure on spending in a number of areas. The Chancellor has stuck with the widely criticised existing fiscal rules. This, therefore, points to increased borrowing and higher taxes.
There are conflicting messages for the markets. Fiscal credibility always goes down well, unless it is seen as being counterproductive to future economic growth. That is the risk here, especially if infrastructure plans are cut now and taxes are on a future upward trajectory, dampening the attractiveness of the UK as an investment destination. Meanwhile, the public sector pay deals may be seen as both non-inflationary and a catch-up to the pace of earnings growth in the private sector.
Finally, events in the US can impact us directly, or indirectly. For example, President Biden’s industrial policy looks like being replicated in parts by the new UK Government. This week also saw the US Federal Reserve keep policy rates unchanged. That did not prevent the MPC from easing.
In coming weeks, attention in financial markets will be heavily impacted by the late August gathering of central bankers in Jackson Hole, Wyoming. Although that will focus on the effectiveness and transmission of monetary policy, a crucial aspect of the forthcoming monetary policy debate in the US and globally (including the UK), will be what might constitute the neutral level for policy rates.
For while the attention of markets is on when and by how much central banks will cut, a key question is where interest rates will settle. Rates need to be high enough to keep inflation in check, while low enough to foster growth. It clearly is far lower than the 5% to which the MPC has cut and perhaps might be in the 4% to 4.5% range for the UK.
Please note, the value of your investments can go down as well as up.
