The market’s reaction to the Bank of England’s interest rate cut today was very interesting indeed.
Sterling fell against both the dollar and the euro as expected – but some market participants expressed skepticism, saying much of the decline, particularly against the greenback, occurred before news emerged that the Monetary Policy Committee (MPC) had cut the central bank’s interest rate.
But even more striking were the declines in yields on government bonds, British government bonds that also serve as the implicit government borrowing cost.
Money breaking: Reactions as Bank of England cuts borrowing costs
The yield on the 10-year bond, which rose to 4.293 percent at the beginning of July, fell to 3.906 percent, a level not seen since March 12.
The yield on 5-year bonds, which rose to 4.121 percent a month ago, fell to the 3.674 percent level last seen on February 1.
It’s down almost 6% this week alone, which is a big drop for this kind of thing.
The yield on 2-year government bonds, which are most sensitive to short-term interest rates, fell from 4.262% at the beginning of July to 3.717% on May 17 last year.
These moves should, in theory, be very good news. Rachel Reevesnew Minister of Finance.
The Treasury (in outgoing Chancellor Jeremy Hunt’s spring budget) estimated that interest payments on the national debt would reach £109 billion this financial year, making it the fourth-highest element of government spending this year after social security, the NHS and education.
So anything that reduces government borrowing should, all else being equal, free up more money for other things – higher public spending, tax cuts or, more bluntly in the current climate, lower government borrowing.
This was already happening to some extent, because 28% of the interest paid on the national debt was pegged to the old RPI inflation measure. But lower bond yields overall would also make Ms Reeves’ job significantly easier.
But the situation also creates a political headache for the new chancellor.
In it The House of Commons’ statement on MondayMs Reeves sought to link spending cuts on roads and rail, the removal of a cap on social care costs and the slashing of winter fuel benefits for 10 million pensioners to the £22 billion fiscal deficit she claims she inherited from Mr Hunt.
This was not entirely true: around £9.4 billion of this deficit was created by his own decision, announced the same afternoon: Hand in hand for wage increases to combat inflation to millions of public sector workers.
But the speech offered a preview of how Ms Reeves will present her upcoming October budget, which is likely to include further tax increases, as she confirmed on Tuesday.
It is clear that the Chancellor proposes to frame these tax increases as an unpleasant decision forced upon him by the state of the public finances – something he would not want to do if conditions were better.
But if the government’s borrowing costs continue to fall – and the market is already pricing in at least one more rate cut from the Bank of England this year – it will become harder for Ms Reeves to make that claim, as she will have less money to spend on interest payments.
This means that the more controversial measures, such as the inheritance tax increases that have been sought to soften public opinion and the crackdown on tax breaks for people saving for retirement, are being pushed by Ms Reeves because she has chosen to do so, not because they have been imposed on her.
This may explain why Ms Reeves reacted with some caution to the Bank of England’s move at midday.
“I am focused on making tough decisions to strengthen the foundations of our economy,” he said.
The Chancellor also hit back at claims that the pay rises she announced on Monday would fuel inflation.
He added: “It is the Bank of England’s responsibility to make decisions on interest rates and inflation forecasts. On Monday I took the decision to give our armed forces, police, teachers, doctors and nurses a pay rise – I think it is the right thing to do.
“But we also found efficiencies in government spending that offset some of the increase in wages.”
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Bank of England Governor Andrew Bailey had to answer similar questions when he appeared before the press today to explain his decision.
“First of all, we’re going to take a lead from the private sector in terms of wage indicators, because private sector wages are directly reflected in consumer price inflation,” the governor said when asked if the wage increases Ms. Reeves will pay this week will lead to inflation.
“But public sector wages clearly have an impact on demand and can have a signalling effect. I think, generally, private sector wages are leading public sector wages and that’s what we’ve seen recently.
“The second point I’ll make is… if you do a very simple ‘behind the scenes’ on the public sector pay rise that the Chancellor announced… the famous ‘behind the scenes’ shows an increase in inflation… which is very small – you’re in very small second decimal places.”
This suggests Mr Bailey is fairly confident that wage increases will not fuel inflation in the coming months.
But there is little doubt that this could make the MPC’s decision even more difficult.
In the meantime, expect Ms. Reeves to refute the claim that falling government borrowing costs will eliminate the need for tax increases at every opportunity.