It is not that long ago that the UK appeared set for a sustained easing cycle. With inflation falling sharply and other central banks cutting rates, the Bank of England’s monetary policy committee was expected to bring rates down steadily. But the Autumn Budget — which the Office for Budget Responsibility and many other forecasters consider will add to inflation — and an uptick in actual inflation in October, have caused investors to recalibrate their expectations towards a more gradual path of easing. At Fathom, we now only expect one more 25-basis-point cut to Bank Rate between now and October next year, which is less than the consensus.[1]
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This recalibration is reflected in the yield on UK government bonds, which has risen significantly since the summer. This contrasts with the outlook in Europe, where inflation continues to ease, and the fiscal policy stance appears tighter and less inflationary. The divergence between the UK and its continental neighbours is also reflected in the outlook for short-term interest rates and has pushed the yield spread between longer-dated UK government bonds and German government bonds to its highest level in more than two years. This, in turn, has pushed sterling higher against the euro. Good news for UK holidaymakers, then, but not such good news for UK homeowners, or for those that need to refinance their mortgages, as the second chart below highlights.
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Although inflation has been sticky and the labour market tight, UK economic growth has hardly been spectacular: the economy barely grew in Q3, while the four-quarter growth rate has not exceeded 1% in any of the last seven quarters. The threat of stagflation looms — i.e., low growth and high inflation — which is not a desirable economic place to be. This is why the UK’s new government is keen to borrow more to invest, while at the same time ringfencing this borrowing from certain fiscal rules and also from the borrowing needed to pay day-to-day bills.
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All of this leaves the UK’s central bank with a conundrum. If it keeps policy too tight it risks weakening an already weak economy; but if it loosens too fast it risks inflation becoming entrenched. Ultimately, to move away from the threat of stagflation, the UK needs to find ways to become more productive. As the chart below highlights, output per worker has barely budged since 2017. There are many ways that UK could try to reverse this, such as increasing spending on R&D, but nearly all of these are outside the remit of the Bank of England. For more on the UK’s productivity problem and how to solve it, see the Chart of the Week from 9 December.
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The views expressed in this article are the views of the author, not necessarily those of LSEG.
[1] For more about Fathom’s view on the UK see the Chartbook, where charts and analysis from our Global Outlook, Winter 2024 are available.
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