Today, the Bank of England made the decision to cut interest rates, resulting in a notable market reaction. As expected, the British pound decreased in value against both the US dollar and the euro. However, what caught the attention of some was the majority of the decline against the US dollar occurring before news of the rate cut was announced by the monetary policy committee (MPC).
The most significant reactions were seen in the yields on gilts, which are UK government bonds that represent implied government borrowing costs. The 10-year gilt yield, which was at 4.293% at the beginning of July, dropped to 3.906% – a level not seen since March 12th. Similarly, the 5-year gilt yield, which was at 4.121% a month ago, fell to 3.674% – a level last seen on February 1st. These moves, while significant, are not uncommon in the market and have the potential to greatly benefit the new Chancellor of the Exchequer, Rachel Reeves.
With the national debt projected to reach £109bn this year, reducing government borrowing costs would free up more funds for other areas such as public spending, tax cuts, or simply lowering government borrowing. This trend was already in motion, as a portion of the interest paid on the national debt is fixed to the old RPI measure of inflation. However, the decrease in gilt yields will further ease Ms. Reeves’ responsibilities in managing the country’s finances.
On the other hand, this also presents a political challenge for the new Chancellor. In her statement to the House of Commons on Monday, Ms. Reeves attributed spending cuts on roads, railways, and social care costs to an inherited fiscal shortfall of £22bn from her predecessor, Jeremy Hunt. However, it was revealed that a significant portion of this shortfall was created by Ms. Reeves’ decision to give inflation-busting pay rises to public sector workers. This announcement gave a glimpse into Ms. Reeves’ upcoming October budget, which is expected to include tax increases.
As the market continues to price in the possibility of further rate cuts from the Bank of England this year, it becomes increasingly difficult for Ms. Reeves to justify these tax increases as necessary due to the state of the public finances. This raises the question of whether these measures are being implemented out of necessity, or if they are a deliberate choice by the Chancellor.
In response to the Bank of England’s decision, Ms. Reeves gave a guarded reaction, stating that she remains focused on making difficult decisions to stabilize the economy. She also pushed back against suggestions that the pay rises she awarded on Monday would contribute to inflation, citing that the Bank of England is responsible for forecasting inflation.
During the press conference to explain the rate cut decision, Bank of England Governor Andrew Bailey was also asked about the potential inflationary impact of the pay increases. He stated that the Bank looks to the private sector for pay indicators, as it directly affects consumer price inflation. He also mentioned that while public sector pay can have a signaling effect on demand, it typically follows the trend of private sector pay.
Mr. Bailey also noted that the increment to public sector pay announced by the Chancellor would have a minimal impact on inflation. While he is confident that the pay increases will not lead to inflation in the near future, it could potentially complicate future decisions made by the MPC.
In the meantime, Ms. Reeves is expected to reject any notion that falling government borrowing costs will lessen the need for tax increases.
