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Roula Khalaf, Editor of the FT, curates her top stories in this weekly newsletter.
The writer is senior vice-president and economist at Pimco
UK government bond yields have experienced a turbulent start to the year. After a sharp rise in the first two weeks — approximately 0.3 percentage points for five-year gilts — they have now returned to their initial levels. While there has been speculation around fiscal policy, the fluctuations have been primarily influenced by global factors. Similarly, US bond yields have displayed similar volatility.
The UK bond markets may be more attuned to fiscal credibility following the upheaval post the 2022 Liz Truss budget. However, the fiscal sustainability in the UK does not significantly differ from certain counterparts such as France, which has a higher fiscal deficit and a faster-growing debt.
Despite this, the UK stands out on the policy front. With the Bank of England’s policy rate currently at 4.75 per cent, it is the highest among major developed countries, impacting economic activity. Economic growth has been stagnant since summer, with a notable decline in labor demand. Inflation has eased over the past year and is now hovering around the “two-point-something” range, close to the BoE’s target of 2 per cent. Consequently, the BoE reiterated its intention to lower its policy rate at its December meeting.
However, the question remains: how low will it go? Unlike many central banks, the BoE has not provided clear guidance on this matter. Estimating the equilibrium rate, where monetary policy is neither tight nor loose, requires a degree of humility. It is contingent on factors that influence the supply and demand for capital, which naturally evolve over time.
One way to estimate this rate is by analyzing economic growth. Countries with high growth rates tend to attract more investment and discourage saving, leading to higher rates. By this yardstick, the market’s anticipated long-term interest rate in the UK appears elevated. Productivity has only risen by 0.5 per cent (annualized) since the onset of the pandemic, slightly below its pre-pandemic level and less than one-third of the US figure. Moreover, the actual productivity might be even lower due to ongoing issues with labor force survey data, which likely under-reports employment levels.
Inflation also exerts upward pressure on interest rates. While core inflation in the UK stands at 3.2 per cent over the past year — slightly higher than many other developed nations — it is on a downward trajectory. Underlying price pressures, excluding one-time tax shocks, are alleviating, particularly in the services sector. Based on medium-term inflation expectations, the central bank’s credibility remains intact, and there are few reasons to believe that the UK will sustain structurally higher inflation compared to other countries.
Nevertheless, markets remain skeptical, foreseeing only a few cuts ahead with a final target of around 4 per cent. This outlook may stem from concerns that increased government spending could fuel inflation. Market participants might also doubt the government’s commitment to its new fiscal rules, given its track record of adjustments. Like Italy, but unlike most other major developed nations, the UK borrows money at a significantly higher interest rate than its underlying economic growth rate, exacerbating debt dynamics.
We hold a more optimistic view on inflation, notwithstanding the added uncertainty from fiscal policy. Despite the uptick in government spending, taxes are set to increase as well, maintaining a tight fiscal policy. This overall effect is likely to dampen activity and employment, as evidenced in recent surveys. While firms may pass on some of the National Insurance hike to consumers, it would constitute a price-level adjustment — akin to a value-added tax or tariff hike, which central banks typically overlook. Therefore, we anticipate UK gilt yields to decrease. Presently, the five-year gilt yield is marginally lower than that of the US, and we foresee it dropping below the US level in due course, akin to the trend in the five years pre-pandemic. Despite the lingering risk of rising rates — as short-term inflation expectations have inched up recently — there are more indications pointing towards rate reductions, given the heightening global trade uncertainty, stringent fiscal policy, and an overall subdued growth outlook.
Regarding the policy rate, our internal models suggest a neutral interest rate of 2 to 3 per cent in the UK. Even if the BoE proceeds cautiously with rate cuts in the first half of the year, we envision a greater potential for the rate to decrease more than what the market anticipates. The BoE might eventually follow suit with other central banks like the European Central Bank, Bank of Canada, Reserve Bank of New Zealand, and the Riksbank, by pivoting towards swifter rate cuts.