Interest rates might not need to rise as much as the market expects, Bank of England deputy governor Ben Broadbent said in a speech, which led to UK government bond prices strengthening further.
The yields on two-year, 10-year and 30-year gilts all fell on Thursday, pushing down government borrowing costs, on the same day that markets were also reacting to the resignation of Liz Truss as Prime Minister.
Expected UK interest rates had been easing since new Chancellor Jeremy Hunt U-turned on many of Truss's policies earlier in the week.
Speaking at Imperial College London, Broadbent explained that the economy has been hit by severe real shocks.
“The pandemic raised the global demand for goods and reduced their supply; Russia has cut back severely its supply of gas to Europe. These have had dramatic effects on relative prices.
“In particular, import prices have risen significantly compared with the price of UK output. This has unavoidably depressed real incomes: the volume of output may have just about recovered to pre-Covid levels but its consumption value has not.”
Broadbent said that the Bank’s Monetary Policy Committee will respond promptly to news about fiscal policy adding that the justification for tightening monetary policy is clear.
It was suggested by some market observers that if the markets takes the deputy governor seriously, the expected bank rate will continue to reduce.
This could not only lead to lower debt interest service costs for the government – in time to shrink the fiscal ‘black hole’ being addressed by Hunt, but also lower mortgage rates.
With interest rates still seen rising from current levels, economists are forecasting a drawn-out recession for the UK.
The drag on the economy from CPI inflation being stuck at 10% for a year and interest rates rising to 5.00% will trigger a recession that involves real GDP declining by around 2.0% from its peak to its trough, predicted Paul Dales, chief UK economist at Capital Economics.
Dales said whoever takes over from Truss as PM will probably have to tighten fiscal policy in the medium-term fiscal plan on 31 October rather than just reverse the previous loosening, "to prove their fiscal restraint to the financial markets".
"As such, it’s possible that the recession will be deeper. Weaker GDP will contribute to an easing in domestic price pressures, but just not soon enough to prevent the Bank of England from raising interest rates from 2.25% now to 5.00%."
Dales sees the BoE pivoting to rate cuts in 2024 once inflation is conquered, in order to help stimulate the weak economy.
Samuel Tombs at Pantheon Macroeconomics sees rates rising to a peak of 4% early next year before being slowly trimmed by the Bank in 2024, though he still expects a recession with a 1.5% year-on-year decline in GDP in 2023 and a modest 0.5% recovery in 2024.
He estimates Hunt will target further annual savings of about £50bn at his statement a week next Monday, implying real-terms spending reductions of 0.4% per year on average over the next three years, similar to David Cameron-George Osborne austerity regime in the early 2010s.
"We doubt that the next PM can stop this tightening, even if they want to; Mr. Hunt is effectively unsackable, as he is implementing the policies bond investors want to see," said Tombs.
Accordingly, he thinks the BoE's monetary policy committee will raise rates by 75 basis points at the next meeting, on 3 November, rather than by the 100bps seen as most likely by markets.
Pausing rates at 4% early next year would "put renewed downward pressure on sterling", Tombs said, but he think the MPC "will judge that the medium-term outlook for domestically-generated inflation is so low that some imported inflation can be tolerated".
"We then expect the MPC to start to reduce Bank Rate in 2024, though it may take a long time for it to return to the 2-to-2.5% neutral range, if fiscal policy is loosened up again in the run-up to the next election, or if inflation expectations stay sticky."