How low are UK interest rates?

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author He is senior vice president and chief 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 about 0.3 percentage points for five-year gilts – they are now back where they started. While there is noise around fiscal policy, the moves have been largely driven by global factors. US bond yields showed similar fluctuations.

UK bond markets may be more sensitive to fiscal credibility following the turmoil following the Liz Truss 2022 Budget. But the UK’s fiscal sustainability is not significantly different from some of its peers, including France, which has a higher fiscal deficit and a more rapid increase.

The UK remains an outsider, on the other side of the political ledger. The Bank of England’s policy rate of 4.75 per cent is now the highest among large developed countries. This weighs the activity. Economic growth has stagnated since the summer, and labor demand has fallen sharply. Inflation eased last year and is now in the ‘two-point’ range, close to the Bank of England’s target of 2 per cent. It is not surprising, then, that the NCB/ENBank December meeting reiterated its intention to lower the policy rate forward.

But how far will you go? Unlike many other central banks, Boy He did not provide clear guidance. Estimating the equilibrium rate, where monetary policy is neither tight nor loose, requires a great deal of humility. It depends on factors that affect the supply and demand of 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, it appears that the expected long-term market interest rate in the UK is high. Productivity has increased just 0.5 percent (annual) since the pandemic began, just below the pre-probate rate and less than a third of that in the United States—and actual productivity may be lower due to ongoing issues in labor force survey data, which may be reducing employment levels. .

Inflation puts upward pressure on interest rates as well. Although core inflation in the UK – at 3.2 per cent over the past year – is still slightly higher than in most other developed countries, it is trending down. Underlying price pressures are mitigated, excluding one-time tax shocks, especially in services. Based on medium-term inflation expectations, central bank credibility is sound and we see some reasons why the UK has structurally higher inflation than other countries.

However, markets remain skeptical, anticipating only a few cuts ahead of a final destination of around 4 percent. This outlook may reflect concerns that increased government spending could lead to higher inflation. Markets may also question the government’s commitment to its new fiscal rules, given its recent history of adjustments. Like Italy, but unlike most large developed countries, the UK borrows money at an interest rate well above the underlying economic growth rate, which exacerbates debt dynamics.

We have a more benign central view of inflation, even if we acknowledge that fiscal policy adds uncertainty. Although government spending will increase, taxes will also rise, leaving fiscal policy tight. It is likely to drag down the net impact on activity and employment, as already evident in recent surveys. Businesses may pass on some of the national insurance hike to consumers, but this will be an adjustment to the price level – such as a value-added tax or tariff hike. Normally, this is something central banks look at. We would be very surprised if the government did not adjust taxes or spending to meet its fiscal rules, given recent bond market volatility.

As such, we expect UK gilt yields To retreat. The five-year gilt yield is now only a fraction of that in the US and we expect it to fall below the US level over time, similar to the five years before the pandemic. Although the risks of rising prices remain higher – near-term inflation expectations have risen in recent months – there is more reason to expect prices to fall, given increasing uncertainty in global trade, tight fiscal policy and generally soft growth expectations.

As for the policy rate, our internal models suggest a neutral interest rate of 2 to 3 percent in the UK. Even if BOE is cautious with rate cuts in the first half of this year, we see room for the price to fall by more than the market expects. The Bank of England may eventually follow other central banks, including the European Central Bank, the Bank of Canada, the Reserve Bank of New Zealand and the Riksbank in pivoting to faster cuts.