Bank of England: How Low Will Interest Rates Go?
U.K. government bond yields are off to a volatile start to the year. After rising sharply in the first two weeks – by roughly 30 basis points for five-year gilts – they are now slightly below where they started. While there is noise around fiscal policy, the moves have largely been driven by global factors – German and U.S. bond yields have exhibited similar volatility.
Bond markets in the U.K. may be more sensitive to fiscal credibility following the turbulence after the 2022 Liz Truss budget. But fiscal sustainability in the U.K. does not significantly differ from some peers, including France, which has a higher fiscal deficit and more rapidly rising debt.
The U.K. remains an outlier, however, on the other side of the policy ledger: The Bank of England’s (BoE) policy rate of 4.75% 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%. 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 (such as the Federal Reserve, which sees its long-run median projection, or “dot”, at 3%), the BoE has not provided clear guidance.
Nailing down the neutral rate
Estimating the equilibrium policy rate, also called the neutral rate or r-star, 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 U.K. seems high. Productivity has only increased by 0.5% (annualised) since the pandemic began, slightly below its pre-pandemic rate and less than a third of that in the U.S. – and actual productivity may be even lower due to ongoing issues with the labour force survey data, which likely underreports employment levels.
Inflation puts upward pressure on interest rates, too. Although core inflation in the U.K. – at 3.2% over the last 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 U.K. will have structurally higher inflation than in other countries.
Yet markets remain skeptical, expecting only a few cuts ahead to a final destination of just below 4%. This outlook may reflect lingering risks from fiscal policy. One concern is that increased government spending could lead to higher inflation. Another worry is that high deficits and borrowing costs might damage the government’s fiscal credibility. Like Italy, but unlike most other large, developed countries, the U.K. borrows money at a much higher interest rate than its underlying economic growth rate, worsening debt dynamics. Markets might also question the government’s commitment to its new fiscal rules, given its recent history of adjustments.
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 likely 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 VAT or tariff hike – something central banks typically 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.
Investment implications
As such, we expect U.K. gilt yields to decline. The five-year gilt yield is now only a fraction lower than that in the U.S. and we expect it to fall below the U.S. 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% in the U.KFootnote1. Even if the BoE is cautious with rate cuts in the first half of next year, we see room for the rate to fall by more than the market expects. The Bank of England 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.
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