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Higher government spending will likely force the Bank of England to slow the pace of interest rate cuts over the coming year, economists have warned.
Chancellor Rachel Reeves is hoping to raise £40bn in next week’s Budget to help fund higher spending on public services. This will largely come through higher taxes.
Alongside these measures, Reeves is likely to reform the fiscal rules to allow for more government borrowing to fund public investment.
Economists at Pantheon Macroeconomics said the “growth-depressing impact” of higher taxes would likely be “roughly cancelled out” by the boost to day-to-day spending.
However, the likely increase in investment will provide a bigger boost to growth. “Government investment has a much bigger impact on GDP growth than tax hikes do,” Rob Wood, chief UK economist at Pantheon Macroeconomics, said.
Wood expects Reeves to increase borrowing by an average of £17.2bn per year over the next three years, providing a 0.5 per cent boost to GDP in 2025/26.
As a result, he estimated that the Bank Rate would have to be 50 basis points higher in 2025/26 compared to what it would have been under the previous government’s fiscal plans.
“The MPC can keep cutting interest rates, but Ms. Reeves’ Budget should keep rate-setters easing policy only gradually,” he said.
Analysts at Capital Economics agreed that an increase in public investment would complicate life for rate-setters at the Bank of England.
“The direct boost to GDP from a rise in public investment over the next few years would raise demand relative to supply. That could mean inflation is a bit higher than otherwise and interest rates are cut more slowly,” Paul Dales, chief UK economist at Capital Economics, said.
Still, Dales argued that a well-directed programme of investment would boost supply capacity in the longer-term, which would enable interest rates to be a bit lower.
The Bank of England cut interest rates for the first time since the pandemic back in August and policymakers are expected to reduce rates again next month.
Traders have steadily built up bets that the Bank will adopt a more aggressive approach next year as inflation has continued to moderate.
