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Writer is a senior vice president and economist at PIMCO
UK 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 were largely driven by global factors. US bond yields showed similar volatility.
UK bond markets may be more sensitive to fiscal credibility following the turbulence following Liz Truss’s 2022 budget. But fiscal sustainability in the UK is not significantly different from some peers, including France, which has a larger fiscal deficit and faster-growing debt.
The UK, however, remains an outlier on the other side of the policy ledger. The Bank of England’s policy rate of 4.75 percent is now the highest among major developed countries. It’s activity weighing. Economic growth has stagnated since the summer, and demand for labor has fallen sharply. Inflation has moderated in the past year and is now in the “two point” range, close to the BOE’s 2 percent target. It is therefore not surprising that at its December meeting the BOE reiterated its intention to lower the policy rate ahead.
But how low will it go? Unlike many other central banks, Boe did not provide clear guidance. Estimating the equilibrium rate, where monetary policy is neither tight nor loose, requires great humility. It depends on factors affecting the supply and demand of capital, which naturally change over time.
A simple way to estimate is by looking at economic growth. High-growth countries attract more investment and encourage less savings, pushing rates higher. By this measure, the expected long-term interest rate in the market seems high. Productivity has increased by 0.5 percent (annually) since the pandemic began, slightly below its pre-pandemic rate and less than a third in the U.S. Real productivity may be even lower thanks to ongoing problems with the labor force survey Data, which likely underestimates the level of employment.
Inflation also puts pressure on interest rates. Although core inflation in the UK – 3.2 per cent over the past year – has remained slightly higher than in most other developed countries, it is on trend. Underlying price pressures, excluding one-off tax shocks, are easing, especially in services. Based on medium-term inflation expectations, central bank credibility is intact and we see several reasons why the UK will have structurally higher inflation than elsewhere.
Still, markets remain skeptical, expecting only a few cuts ahead of the 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 other large, developed countries, the UK borrows money at a much higher interest rate than its underlying rate of economic growth, exacerbating debt dynamics.
We have a more benign central outlook for inflation, even if we acknowledge that fiscal policy adds uncertainty. Despite increased government spending, taxes will also rise, and fiscal policy has remained firm. The net effect is likely to drag on activity and employment, which is already evident in recent research. Companies can pass on some of the national insurance to consumers, but this would be an adjustment to the price level – like value added tax or a tariff excursion. This is usually something central banks look at. And we’d be very surprised if the government didn’t adjust taxation or spending to meet its fiscal rules, given the recent volatility in the bond market.
As such, we expect UK returns refuse. The five-year gilt yield is now only a fraction lower than 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 rates going higher—short-term inflation expectations have been rising in recent months—there is more reason to expect rates to fall, given heightened global trade uncertainty, tight fiscal policy and a generally soft growth outlook.
In terms of the policy rate, our internal models point to a neutral interest rate of 2 to 3 percent in the UK. Even if the BOE is cautious about cutting rates in the first half of this year, we see room for a rate cut by more than the market expects. The BOE could 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 tapering faster.
