All eyes on 30 October
Knocks to consumer confidence and a possible reaction from bond investors relating to UK Budget concerns should be temporary.
- In any case, heightened tensions in the Middle East as well as policy changes arising from the US election may end up having a far more material impact on the UK economic outlook.
- Our base-case scenario for interest rates to gradually fall to 3% by mid-2026 remains.
We pointed out in the last Rate Wrap that UK consumer confidence took a dip in September as worries associated with the upcoming Budget have come to the fore. Early October also saw a spike in UK government borrowing costs, which some commentators interpreted as bond markets expressing concerns about reports that Chancellor Reeves is set to change her fiscal rules.
Since then, gilt yields dropped again but it is worth briefly looking at what prompted the early October jump in yields. The first thing to emphasise is that the increase in gilt yields will likely, in large part, be attributable to a change in inflation expectations following a strong US payrolls report. Moreover, the element of the increase that is down to any concerns related to prospective changes to fiscal rules should be short-lived. The proposed change to the debt rule would give Chancellor Reeves more flexibility on capital expenditure but it would not give more scope to increase current spending, so this should not have a long-term impact on the way that financial markets perceive the UK’s long-run fiscal sustainability.
Citi analysts currently estimate a central scenario of £17bn of headroom against the target of running a current budget surplus. However, it must be stressed that this assumes “status quo spending” that would mean that there are real-terms cuts to various government departments, something that the Chancellor will want to avoid. So it seems inevitable that tax rises are coming. It is pretty clear what the Chancellor will not do at the Budget: changes to income tax rates, employee National Insurance Contributions, VAT, corporation tax rates and pensions tax relief have all been effectively ruled out. We may see changes to employer’s national insurance contributions, capital gains tax, inheritance tax and various duties, but we of course can’t be sure until 30 October.
The Budget may end up having an impact on the UK economic outlook – either to the downside or the upside – but international events over the next few weeks could end up being far more influential. Heightened tensions in the Middle East have the potential to lead to a wider regional war, something we are not envisaging at the moment but nonetheless would have the potential to cause major disruption to global energy markets. And, of course, the US election comes just one week after the UK Budget, which could lead to a ramping up of trade restrictions between the US and China. The world’s two largest economies would no doubt bear the greatest proportional impact from this, but open economies such as the UK would also suffer. There are, however, nuances: for example, the direct impacts to the UK would be mitigated if any global increase in tariffs were restricted to goods: around two thirds of UK exports to the US are services.
It is a difficult environment to make projections but the economic forecasts we laid out in the latest Global Macro Forecast remain our “base-case scenario”. This includes our projections for UK interest rates. The next Monetary Policy Committee (MPC) interest rate decision will be on 7 November, the same date as the US Federal Reserve and Sweden’s Riksbank as it happens, and it would seem almost certain that a further cut in rates will take place. But we continue to believe that the pace of interest rate reduction from thereon will be cautious, with our base-case view being that rates will fall at a gradual pace to 3% by the middle of 2026. While the Bank of England governor has talked about the prospect of more aggressive rate cuts, it is notable that other MPC members such as the Chief Economist Huw Pill continue to remain concerned that structural changes in the UK economy may require monetary policy to be restrictive for longer.
Daniel Mahoney, UK Economist