(Bloomberg) -- Chancellor of the Exchequer Rachel Reeves’ first UK budget got a difficult reception from the markets. The Bank of England is taking a more supportive approach.
Gilt markets convulsed last week as investors digested the impact of £142 billion ($184 billion) of extra borrowing over the next few years. One concern has been that the tax-heavy spending plan, which the government’s fiscal watchdog deemed inflationary, could slow BOE Governor Andrew Bailey’s path to rate cuts.
While the BOE acknowledged on Thursday that Reeves’ policies would push up inflation by almost half a percentage point to a peak of 2.8%, Bailey told reporters on Thursday that there was no immediate need to change the trajectory of easing. The governor made the comments after reducing the bank’s benchmark rate by one-quarter percentage point to 4.75%.
That extends the break the central bank’s policies have offered Reeves since she became chancellor. In her four months in the job, the BOE has lowered borrowing costs twice and held them once – a complete reversal from the 14 hikes her Conservative predecessors faced in the two years from the end of 2021.
On Thursday, the BOE effectively endorsed a further four quarter-point rate reductions to 3.75% by the end of next year, with its forecasts showing inflation dropping below the 2% target even after that much monetary loosening.
“That policymakers are guiding markets to further cuts despite the fact that inflation will remain above target until 2027 suggests they have a strong implicit bias towards cuts,” said Kallum Pickering, chief economist at Peel Hunt.
The Labour Party’s first budget has been rippling through the UK economy for weeks, as analysts, investors and corporate executives attempt to assess the impact of the biggest package of tax increases in a generation. Hiring at British businesses fell in October at steepest pace since March as employers paused intakes in anticipation of the budget, the Recruitment & Employment Confederation and KPMG said on Friday.
The report by the Recruitment & Employment Confederation and KPMG also found that wages for permanent jobs cooled further in October, rising at their slowest pace since 2021, while vacancies declined.
The BOE, which wields the powerful lever over interest rates, has a more generous outlook than the government’s independent fiscal forecaster. The Office for Budget Responsibility said last week that Reeves’ budget would cause the economy to overheat, pushing up prices.
The BOE assumes the opposite: The economy never grows fast enough to close the “output gap” and therefore never suffers inflationary overheating, according to the analysis it published on Thursday.
Bailey also weighed in on the immediate and tumultuous financial market response to Reeves’ budget, which briefly provoked comparisons with the meltdown caused by Liz Truss’ mini-budget disaster in 2022.
He described last week’s moves, when government bond yields on two-year notes jumped more than 25 basis points over fears her plans would fan inflation, as an “orderly reaction” caused by investors repositioning their portfolios.
The wobble “wasn’t surprising to me,” the governor said. Most of it was caused by “the US election, not anything going on in this country.”
Equally positive was the BOE’s outlook for the economy and households. In the view of its officials, Reeves’ budget will lift gross domestic product by 0.75%; unemployment will be lower than previously projected at 4.25% over the next three years; and real post-tax labor income will be better than thought before the budget.
That’s despite a £26 billion increase in payroll tax imposed on employers — National Insurance Contributions — three quarters of which the OBR believes will be passed on to workers in lower pay over time.
Bailey said it’s too early to pass judgment on the impact of that measure. It was Reeves’ biggest tax policy, accounting for over half the total £40 billion increase.
The cost may be passed on in higher prices, lower wages, squeezed profit margins or more unemployment, according to the BOE’s analysis.
“There is a lot that we will learn,” Bailey said. “I think it is important that we have time to do that. We’ll need to see how these effects pass through.”
Homeowners are equally safe under Reeves, the BOE also concluded. Asked if the increase in market rates would push up mortgage costs, Bailey said: “I don’t think it is sensible to conclude that the path of interest rates will be particularly different in that respect.”
Around 800,000 fixed-rate mortgages on a rate below 3% need to be refinanced every year until the end of 2027, the BOE’s report said.
Bailey told Bloomberg Television that it was “reasonable to expect” a response from markets to the budget and that he had told Reeves as much. After five years as governor, he says that such communication is par for the course.
“I am on my fifth chancellor since I started the job. I talk to all chancellors regularly, and all chancellors about markets,” he told reporters. “It’s a regular thing to do – an important piece of coordination.”
--With assistance from Tom Rees and Irina Anghel.
(Updates with recruitment survey in seventh paragraph.)
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