Will the Bank of England reduce charges to again Reeves’s development mission?

There are few British chancellors who have had as much insight into Bank of England thinking as Rachel Reeves.

As a junior Bank of England official, who moved on to help set interest rates at leading mortgage provider HBOS, Reeves (pictured) enjoyed an insider view of the process.

Reeves’s job at the Bank was to help produce the international background to the Inflation Report which is used by the nine members of the interest rate-setting Monetary Policy Committee (MPC).

Most of the thinking about interest rates focuses on hitting the headline rate of inflation of two per cent, as the Bank likes to say, ‘at all times’.

In making that judgment, both global and budgetary factors are important components.

Much of the focus of the Chancellor’s summer ‘audit’ of Britain’s public finances is on the political. A government which regards planning reforms as the key to unlocking its growth mission is cancelling major infrastructure projects – such as the long much-debated road tunnel under Stonehenge – in order to stick with fiscal goals.

That suggests a degree of seriousness about controlling borrowing and debt, which is reassuring to financial markets.

Indeed, both sterling – which has been firm since the election on July 4 – and falling gilt yields, suggest that the MPC can be more confident about cutting bank rate from the current 5.25 per cent than was the case previously. There should be no fear of a bond market eruption.

Quite the contrary. When inflation was running well above target, as a result of Covid-19 supply chain problems and Russia’s brutal war on Ukraine, it was critical that budgetary policy and interest rate policy were moving in the same direction.

The Tories’ battle with the trades unions was about holding the line on public sector pay so a wage price spiral could be avoided.

Now that inflation is close to target that battle essentially has been won even though the Bank has been cautious about the labour market and rises in average pay.

As the governor Andrew Bailey has argued on several occasions, UK and European inflation largely can be attributed to supply chain bottlenecks and energy costs.

There has been no wage-price spiral as in the 1970s and Reeves is making sure that the public pay sector settlements, as set by the independent review bodies, will be properly funded.

That provides the Bank of England with an opportunity. Every Monetary Policy Committee meeting starts with a fiscal briefing from the Treasury ‘observer.’

The reassurance this time around that there is to be no gambles with the public finances opens the opportunity to start cutting British rates. 

Market conditions have improved the odds on a rate cut as a firmer pound cuts the cost of raw materials, in particular oil, most of which are priced in dollars.

International events, as learned bitterly after the invasion of Ukraine, can also have a dramatic impact on domestic conditions.

High interest rates, for a lengthy period of time, were a response to the oil price shock.

That has now passed and a sensible and classic economic response to geo-political uncertainty, such as the present threat of all-out conflict between Israel and Hezbollah on the Lebanon/Syrian front, might be to lower rates to prop up confidence.

Bailey has a terrific opportunity to lead from the front this week and cut rates by a quarter point. The Bank held off in the election campaign. 

Other central banks, including the UK’s neighbours at the European Central Bank, the Swiss central bank and G7 member Canada, have chosen to cut rates.

They have moved ahead of the United States where strong domestic demand has constrained the American central bank, the Federal Reserve. 

Bailey is just one vote on the MPC, but interest rate setters, especially when several are insiders, should be persuaded to follow the governor’s leadership.

By most accounts, the MPC decision is finely balanced this time. Chief economist Huw Pill has warned that the main drivers of UK inflation a showing ‘uncomfortable strength’ could be the main obstacle.

At least one insider, Dave Ramsden, has joined the minority seeking lower rates.

New MPC member Clare Lombardelli, a former Treasury and OECD economist, is an unknown quantity. What we do know from OECD forecasts is that she has been cautious about UK growth.

She may feel that with consumer prices under control, it is time to back Labour’s growth mission. Getting interest rates down and boosting housebuilding is a key part of that.

Lowering interest rates could provide a double boost for the Chancellor.

Not only could it help growth, firmly re-established by the time she took office, but it will save the Exchequer money.

Commercial banks will receive a lower interest rate on overnight deposits cutting the Treasury’s exposure. Moreover, lower rates will slash the cost of servicing the national debt.

It is high time for the Bank to shed its caution, recognise that inflation is defeated and get behind higher output and prosperity.