UK fiscal splurge limits BoE’s rate-cutting space

Rachel’s choice. Rachel Reeves’ big fiscal feast risks giving Bank of England indigestion. new Labour finance minister’s decision to hike spending, taxes and borrowing in budget will provide a short-lived boost to growth next year. But it will also reduce BoE Goverr Andrew Bailey’s ability to cut rates and keep pace with his European and U.S. counterparts.

Reeves’ plan to reduce ecomic slack but may leave Bailey without any of his own. Her budget will raise spending by 70 billion pounds a year until 2030, according to independent Office for Budget Responsibility. That fiscal jolt will double GDP growth from 1% this year to 2% in 2025.

Strapped to public spending rocket, Britain’s ecomy will go from growing below its full potential – when demand is low and re is a surplus of products – to outstripping it. “output gap” – difference between annual GDP growth and its potential – will swing from minus 0.3% in last three months of 2024 to 0.4% in early 2026, OBR calculates. Before budget, it expected gap to remain negative or zero until 2030.

That’s b news for Bailey. A negative output gap helps central bankers because weak demand and excess supply keep inflation quiescent. By contrast, an ecomy growing above potential can easily stoke inflation. BoE is almost certain to lower its benchmark rate from 5% to 4.75% on Thursday because inflation is on course to end year around  2% target. But if Labour’s spending gives ecomy a sugar rush, Bailey will find it harder to cut rates in 2025.

Investors expect UK interest rates to be 4% by end of 2025, according to derivatives prices collected by LSEG. That’s more than double level in euro zone and higher than in United States, where GDP is set to grow by 2.2% next year, according to International Monetary Fund. And since IMF projects that consumer prices will grow by around 2% in three blocs next year, UK will have by far most restrictive monetary policy.

That may be a necessary evil if Reeves’ choices nudge up inflation. And OBR reckons that budget’s impact on growth will dissipate after 2025, opening door to looser policy. However, a prolonged period of high interest rates will exacerbate Britain’s growth challenge, by denting investment and delaying housing recovery. That means bond markets, chief executives and homeowners won’t be able to rest easy for a while.

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Bank of England will cut its benchmark rate from 5% to 4.75% on v. 7, according to all 72 ecomists polled by Reuters. However, nearly two-thirds of m expect BoE to hold borrowing costs stey in December.