(Bloomberg) -- The Bank of England has given Chancellor of the Exchequer Rachel Reeves a £4 billion ($5.3 billion) lifeline to help ease spending pressures ahead of what she has said will be a tough first budget.
The BOE revealed on Thursday alongside its vote to hold interest rates at 5% that it will continue to unwind its gilt portfolio at a pace of £100 billion a year. That hands Reeves about £3 billion of extra headroom against her fiscal rules, so long as the Office for Budget Responsibility sticks to the assumption it has used since Nov 2023, according to calculations by Bloomberg Economics Chief UK Economist Dan Hanson.
A lower path for market interest rates than projected at the March budget gives the chancellor as much as £1 billion over that, Hanson added. Interest rates are expected to settle at around 3.25% in early 2026. Lower prices of oil and other commodities may save Reeves a further £1 billion, Laurence Mutkin, director of rates strategy at BMO Capital Markets, wrote in a note on Sept. 9.
Reeves needs every penny she can find after giving public-sector workers a £10 billion pay rise and uncovering £12 billion of unfunded spending commitments on taking office after Prime Minister Keir Starmer’s landslide election victory in July. She has found £5.4 billion in savings, leaving her to raise taxes or cut welfare to fill the rest of the fiscal hole.
The OBR, the government’s spending watchdog, gave her its first forecast on Thursday, which will determine how much money Reeves needs to find to meet her fiscal rules and stick to her promises to end austerity and increase investment. Her rules require that day-to-day spending must be paid out of taxes and that debt must be falling in five years’ time. A government spokesperson declined to comment on the OBR forecast.
Just as the BOE’s actions will affect Reeves’s budget, decisions she makes in October may impact the path of BOE rate cuts. Henry Cook, a senior economist at MUFG EMEA, said that a “painful” Autumn budget could “have fiscal and monetary policy pulling in opposite directions.” More tax increases and spending cuts could depress growth and “provide scope for a pivot to faster monetary easing,” he said.
On the other hand, if Reeves finds more room to borrow, the BOE may slow the pace of rate cuts. Mutkin said “much of our logic for expecting extensive MPC rate cuts would evaporate,” if Reeves loosens fiscal policy at the budget. Markets currently expect the BOE to reduce borrowing costs by a quarter-point in November and then February.
The BOE signaled in the minutes to this week’s Monetary Policy Committee meeting that government policy remains a risk for the path of interest-rate cuts. It pointed to “some upside risk to pay growth depending on the trajectory of the National Living Wage in the first half of next year” which could prove inflationary and slow the reduction in borrowing costs.
The minutes also highlighted the possibility that Reeves might loosen fiscal policy, noting that the bank’s August growth forecast reflected “the previously announced medium-term tightening in the stance of fiscal policy, prior to the upcoming Budget.”
The BOE’s £3 billion boost to the chancellor is a function of the losses sustained on its Quantitative Easing asset-purchase program to shore up the economy between 2009 and 2021, which peaked at £895 billion. Losses are paid by the taxpayer. The bank is now unwinding the portfolio. Under the current plan it would be down to £558 billion in a year’s time, the BOE said.
The portfolio made £124 billion in profit when rates were near zero, which previous chancellors’ spent. Since 2022 it has lost £73 billion and is on track to lose about £150 billion more over the coming decade.
The BOE is reversing its stimulus through a mix of actively selling bonds and stopping reinvestments when they reach their redemption dates. However, an unusually high amount of bond redemptions, of £87 billion, over the next 12 months reduced the scope for active sales, which will end up falling from around £50 billion to £13 billion.
Currently the OBR takes an average of previous years’ active sales under QT to make its fiscal forecasts. If it sticks to this approach, Reeves would get a £3 billion boost to her fiscal headroom. If it changes its assumption to a £100 billion annual run-off, that would reduce the chancellor’s headroom by a further £5.5 billion, Hanson calculated.
©2024 Bloomberg L.P.
