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Roula Khalaf, editor of the FT, picks her favorite stories in this weekly newsletter.
The writer is senior vice president and economist at Pimco
British government bond yields are off to a volatile start to the year. After rising sharply in the first two weeks – by around 0.3 percentage points for five-year government bonds – they are now back to their original level. While there is excitement about fiscal policy, most of the moves are driven by global factors. US bond yields showed similar volatility.
UK bond markets may be more sensitive to fiscal credibility following the turmoil following the 2022 Liz Truss Budget. However, the UK’s financial sustainability is not significantly different to that of some peers, including France, which has a higher budget deficit and faster-rising debt.
However, the UK remains an outlier on the other side of politics. The Bank of England’s key interest rate of 4.75 percent is now the highest among the major industrialized countries. This puts a strain on the activity. Economic growth has stagnated since the summer and demand for labor has fallen sharply. Inflation has fallen over the past year and is now in the “two percentage point” range, close to the BoE target of 2 percent. It is therefore no surprise that the BoE confirmed its intention to cut its key interest rate in the future at its December meeting.
But how low will it sink? In contrast to many other central banks, the BoE did not provide clear instructions. Estimating the equilibrium interest rate at which monetary policy is neither tight nor loose requires a great deal of humility. It depends on factors that influence the supply and demand for capital and of course change over time.
A simple way to estimate this is to look at economic growth. High-growth countries attract more investment and encourage less saving, leading to higher interest rates. By this metric, the market’s expected long-term interest rate in the UK appears to be high. Productivity has increased just 0.5 percent (annualized) since the start of the pandemic, slightly below the pre-pandemic rate and less than a third of the rate in the U.S. — and actual productivity may have even risen due to ongoing labor force survey issues data that are likely to understate employment levels are even lower.
Inflation also puts upward pressure on interest rates. Although core inflation in the UK is still slightly higher than most other developed countries, at 3.2 percent last year, it is trending downward. Underlying price pressures, barring one-off fiscal shocks, are easing, particularly in the services sector. Based on medium-term inflation expectations, the central bank’s credibility is intact and we see few reasons why the UK will have structurally higher inflation than other countries.
Nevertheless, the markets remain skeptical and expect only a few cuts up to a final target of around 4 percent. This outlook may reflect concerns that higher government spending could lead to higher inflation. Given the government’s recent adjustments, markets may also question the government’s commitment to the new fiscal rules. Like Italy, but unlike most other major developed countries, the UK borrows at a much higher interest rate than its underlying economic growth rate, worsening debt dynamics.
We are more optimistic about inflation overall, although we recognize that fiscal policy adds additional uncertainty. Despite increased government spending, taxes will also rise, leading to restrictive fiscal policy. The net effect is likely to be negative on activity and employment, as already shown in recent surveys. Companies may pass on some of the increase in social security to consumers, but that would be an adjustment in price levels – like a VAT or tariff increase. Typically this is something that central banks pay attention to. And we would be very surprised if the government did not adjust taxes and spending in line with its budget rules, given the recent volatility in the bond market.
As such we expect UK government bond yields refuse. The five-year Treasury yield is now just a fraction below that of the US and we expect it to fall below US levels over time, similar to the five years before the pandemic. While the risks of rising interest rates remain – near-term inflation expectations have risen slightly in recent months – there are further reasons to believe that interest rates will fall given increasing global trade uncertainty, tight fiscal policy and the generally weak growth outlook.
Regarding the base rate, our internal models suggest a neutral rate of 2 to 3 percent in the UK. Even though the BoE is cautious about cutting interest rates in the first half of the year, we see scope for a sharper fall in interest rates than the market expected. The BoE could eventually follow other central banks, including the European Central Bank, Bank of Canada, Reserve Bank of New Zealand and Riksbank, in moving to faster rate cuts.