Great Britain Facing Inflation Challenge: BoE Interest Rate Adjustments Under Review

The British financial markets face a new challenge: Higher inflation expectations could prevent the Bank of England (BoE) from cutting interest rates as much as previously hoped next year. This highlights the divergence in the BoE's monetary policy compared to other central banks worldwide. Rachel Reeves, the new British Chancellor of the Exchequer, recently presented her first budget, which includes the largest tax increases in three decades. Her goal: to repair the country's ailing public services through extensive spending. The UK's independent budget forecaster suggests that these plans could strengthen the world's sixth-largest economy in the short term, but they will also fuel inflation. Next year, a rise in consumer price inflation by half a percentage point is expected. Even before the budget presentation, the conditions in the British labor market and the domestic services sector were considered the driving forces of inflation. The Office for Budget Responsibility (OBR) now forecasts an average inflation rate of 2.6% for next year, above the previous estimate of 1.5%. These prospects have dampened investors' expectations of repeated interest rate cuts by the BoE next year. Although a quarter-point interest rate cut at the next meeting on November 7 remains fairly likely, the new budget raises questions about the further interest rate trajectory next year. Market experts expect about four quarter-point rate cuts by the BoE by the end of next year—a reduction in expectations compared to almost five before the budget announcement. In comparison, the U.S. Federal Reserve and the European Central Bank plan almost five such measures. Andrew Goodwin from Oxford Economics suspects that the BoE will hardly have enough time to promptly integrate the budget impacts into their economic forecasts. If the economic growth predicted by the OBR materializes, this could pose a narrative challenge that justifies faster rate cuts. Following the publication of the OBR's report, British government bonds (Gilts) experienced price losses. Reeves narrowly adhered to her new fiscal rules, yet higher bank rate expectations and bond yields were also forecasted. However, PIMCO economist Peder Beck-Friis remains optimistic about Gilts and expects a long-term shift in market focus towards underlying macroeconomic factors, including abating inflation.