The Budget should not be a big deal for interest rates

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For an hour on Wednesday, the financial market reaction to Rachel Reeves’ Budget was ugly — Truss-like, even. Between 2pm when the chancellor finished her speech and 3pm, UK government borrowing costs rose 0.2 percentage points, whether it was seeking to borrow short or long term.

This was a much higher increase in yields than in equivalent government bond markets on both sides of the Atlantic and nerves must be jangling in the Treasury. Things were not much better on Thursday. If financial markets blow a loud raspberry to a Budget for a second time in just over two years, that would be a significant blow both to households and the Treasury.

There are, however, important differences with Liz Truss’s “mini” Budget debacle. First, the UK market has been calm. Second, rising borrowing costs were not initially combined with falling sterling. In comparison to 2022, foreigners have not been dumping UK assets.

Market reaction appeared to follow the Office for Budget Responsibility’s new forecasts which show that higher public spending would add to demand and inflation, while increased taxes would hit supply.

This all sounds pretty inflationary and the fiscal watchdog said that while it still thought the Bank of England’s policy rate would fall, the Budget measures would leave interest rates 0.25 percentage points higher than it had assumed when initially producing the forecast. More spending, more borrowing and higher taxes equals higher interest rates than otherwise.

This was reasonable analysis from the OBR, which was making a comparison based solely on the outlook now compared with that in March. But it makes little sense for the BoE to follow suit.

The central bank has had ample time to adjust its thinking to Reeves’ announcement on July 29 that public spending would be much higher than the OBR assumed in March. Alongside public finance data that has also pointed to a large spending overshoot, the Budget cannot be much of a surprise.

The key question for the BoE’s Monetary Policy Committee is what was genuine news. This is pretty limited. The increase in public borrowing for 2024-25 caused directly by policy decisions was £23.7bn, just a little higher than the chancellor’s announcement of a £22bn black hole in July.

Whatever you think of the veracity of Reeves’ number, in their meetings in August and September MPC members had known this fiscal stimulus was coming. They did not then think it significant for interest rates. If the BoE says next week that their November meeting was the first time they have considered the effects of Labour’s fiscal plans and these are more inflationary, it would reflect very poorly on its ability to respond to events. For that reason, I think it highly unlikely.

It is also worth noting that the BoE is traditionally loathe to suggest it is responding to loose fiscal policy with higher interest rates. When the former chancellor Jeremy Hunt cut national insurance in late 2023 and early 2024, its reaction was a large shrug.

Based on information we have had for some time, UK fiscal policy is loosening a little this year, but is on a medium-term tightening path, inflation threats have declined significantly and wage pressures have been moderating.

These remain the conditions for the BoE to lower official interest rates with the pace determined by many larger uncertainties than UK fiscal policy. Having suffered a longer-lasting inflationary shock than other European countries, especially in services, the central bank needs to maintain restrictive monetary policy. But it can do so while cutting rates gradually.

The Budget is unlikely to change this reality much. The tax rises were big. The spending increases were bigger. But the broad macroeconomic balance did not alter much on Wednesday.

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