On Thursday (19 December), the Bank of England’s Monetary Policy Committee (MPC) will reveal its latest interest rate decision. Those of us hoping that the recent bad economic news will prompt another cut are set to be disappointed.
Believe it or not, most forecasters still expect Rachel Reeves’ first Budget to boost the economy in 2025. This may seem crazy given that the Budget included tax increases of about £36 billion a year over the next five years.
But on paper at least, this should be more than offset by the Chancellor’s decision to add around £70 billion a year to public spending. Only around half of this will be funded by higher taxes and the rest by additional borrowing.
Roughly two-thirds of this £70 billion will be used to lift the annual real growth of public sector current spending by half a percent. The other third will keep public investment stable as a share of national income, rather than falling as projected under the last government.
The result is a sizeable net ‘fiscal stimulus’, which would normally be expected to add to demand and provide at least a short-term boost to growth.
But this comes with several caveats and costs. One of the most important is higher inflation. The part of the additional spending which is funded by borrowing will increase demand more quickly than it increases supply, using up spare capacity in the economy.
The increases in taxes and other costs in the Budget will also have a more direct impact on prices as firms inevitably pass these on to their customers.
These effects should still unwind over time. Any boost to demand will fade as higher prices and higher government borrowing and spending crowd out activity in the private sector. Beyond that, growth will have to rely on the positive effect that higher public investment might have on the supply-side of the economy.
Fortunately, the impact on the rate of inflation should fade too, as demand cools and the one-off increases in the level of prices work through the data.
The upshot is that the Budget itself may not have a huge impact on the paths for growth or inflation over the medium-term horizon which matters most for monetary policy.
This is consistent with the Bank’s intention to continue to cut interest rates ‘gradually’, perhaps a quarter point alongside each new set of forecasts in the quarterly Monetary Policy Report (MPR).
This is also still roughly what the markets expect. Most members of the MPC will be reluctant to spring a surprise which might add to fears that the economic outlook is much worse than previously thought.
In turn, this suggests that interest rates will be left on hold this week, just a month after the cut in November and two months before the next MPR is published in early February.
Nonetheless, there are a number of factors that could prompt the Bank to step up the pace of easing, and if not the frequency of rate cuts, then perhaps the size. The next move in February might now be more likely to be a half point, rather than a quarter.
And if I were on the MPC, I would make two arguments for a rate cut on Thursday.
One is that the economic outlook is indeed much worse than previously thought. The second successive monthly fall in GDP in October has put the UK firmly on recession watch. Output per head may already be falling for the second quarter in a row.
The Bank of England’s staff forecast of 0.3 per cent growth in the fourth quarter is certainly looking even more optimistic. We may be lucky to see zero.
The loss of momentum is not contained to the UK. Nonetheless, the new government’s gloomy rhetoric over the summer and the anticipation of a tight Budget has damaged sentiment, and households and businesses have put spending and investment on hold.
The Budget itself was even tougher than expected. The large increases in spending, taxation and borrowing were bound to add to uncertainty. It is simply not possible to shift another two per cent of national income from the private to the public sectors without disrupting the economy, especially given the gap in productivity between the two.
Moreover, the purchasing managers’ survey for December, released on Monday, suggests that hiring has collapsed. The negative impacts of the Budget on the labour market should at least dampen fears that services inflation will remain stubbornly high.
The second argument for a rate cut this week involves a step back from the impact of the Budget. Most MPC members assume that rates are currently at the right level and that it would take a lot of bad news to prompt a change of tack from the plan for a series of gradual cuts.
However, the starting point may already be too high. The current Bank rate of 4.75 per cent is well above the neutral level, which is probably between 3 and 4 per cent, especially as the full effect of past increases have yet to feed through.
At the same time, the MPC is continuing to tighten policy by running down its holdings of government bonds – reversing the previous support from ‘quantitative easing’ – and monetary growth is back to a sustainable pace.
If beginning with a blank sheet of paper, interest rates should probably already be down to about 4 per cent. At some point, the Bank of England will shift to worrying much more about the downside risks to growth and inflation – including the downside risks from the Budget.
Perhaps this week is too soon for most members of the MPC, but the Bank cannot wait much longer.
This article was first published in the Daily Telegraph on 18 December 2024
Ps. since I wrote this piece, new data showed that inflation picked up to 2.6% in November. This was disappointing but not surprising – most forecasters (including the Bank of England) were already expecting a temporary rise, even before the main Budget measures kick in next year. Nonetheless, it surely kills off any chance of a rate cut this week.
The jump in the annual growth of private sector regular pay to 5.4% in the three months to October will not have helped either, though I would not give these pre-Budget figures much weight.
Plain-speaking Economics 