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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is senior vice-president and economist at Pimco
UK government bond yields are off to a volatile start to the year. After rising sharply in the first two weeks — by roughly 0.3 percentage points for five-year gilts — they have now returned to where they started. While there is noise around fiscal policy, the moves have largely been driven by global factors. US bond yields have exhibited similar volatility.
Bond markets in the UK may be more sensitive to fiscal credibility following the turbulence after the 2022 Liz Truss budget. But fiscal sustainability in the UK does not significantly differ from some peers, including France, which has a higher fiscal deficit and more rapidly rising debt.
The UK remains an outlier, however, on the other side of the policy ledger. The Bank of England’s policy rate of 4.75 per cent is now the highest among large developed countries. That is weighing on activity. Economic growth has stagnated since the summer, and labour demand has fallen sharply. Inflation has eased in the past year and is now in the “two-point-something” range, close to the BoE’s target of 2 per cent. It’s no surprise, then, that at its December meeting the BoE repeated its intention to lower its policy rate ahead.
But how low will it go? Unlike many other central banks, the BoE has not provided clear guidance. Estimating the equilibrium rate, where monetary policy is neither tight or loose, requires a great deal of humility. It depends on factors affecting the supply and demand for capital, which naturally change over time.
A simple way to estimate it is by looking at economic growth. High-growth countries attract more investment and encourage less saving, pushing rates higher. By this measure, the market’s expected long-term interest rate in the UK seems high. Productivity has only increased by 0.5 per cent (annualised) since the pandemic began, slightly below its pre-pandemic rate and less than a third of that in the US — and actual productivity may be even lower owing to ongoing issues with the labour force survey data, which probably under-reports employment levels.
Inflation puts upward pressure on interest rates, too. Although core inflation in the UK — at 3.2 per cent over the past year — remains slightly higher than in most other developed countries, it’s trending down. Underlying price pressures, excluding one-time tax shocks, are easing, especially in services. 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 in other countries.
Yet markets remain sceptical, expecting only a few cuts ahead to a final destination of around 4 per cent. This outlook may reflect concerns that increased government spending could lead to higher inflation. Markets might also question the government’s commitment to its new fiscal rules, given its recent history of adjustments. Like Italy, but unlike most other large, developed countries, the UK borrows money at a much higher interest rate than its underlying economic growth rate, worsening debt dynamics.
We have a more benign central view for inflation, even if we acknowledge that fiscal policy adds uncertainty. Despite increased government spending, taxes will rise too, leaving fiscal policy tight. The net effect will probably drag on activity and employment, as already evident in recent surveys. Firms may pass some of the National Insurance hike on to consumers, but that would be a price level adjustment — like a value added tax or tariff hike. Typically, that is something central banks look through. And we would be very surprised if the government did not adjust taxation or spending to meet its fiscal rules, given the bond market’s recent volatility.
As such, we expect UK gilt yields to decline. The five-year gilt yield is now only a fraction lower than that in the US and we expect it to fall below the US level over time, similar to the five years before the pandemic. While the risks of rates going higher remain — near-term inflation expectations have edged higher in recent months — there are more reasons to expect rates to fall, given increased global trade uncertainty, tight fiscal policy and a generally soft growth outlook.
As for the policy rate, our internal models point to a neutral interest rate of 2 to 3 per cent in the UK. Even if the BoE is cautious with rate cuts in the first half of this year, we see room for the rate to fall by more than the market expects. The BoE might eventually follow other central banks, including the European Central Bank, Bank of Canada, Reserve Bank of New Zealand and the Riksbank in pivoting to faster cuts.
