Can the Bank of England still cut interest rates this week under the impact of the budget proposal and the U.S. election?

According to the Zhitong Finance APP, hopes for the Bank of England to accelerate interest rate cuts this week may be dashed, as the budget announced by the UK government has reignited inflation concerns and triggered a sell-off in UK bonds, reminiscent of the market crash in 2022. Previously, economists and traders expected the Monetary Policy Committee (MPC) of the Bank of England to proceed with its second interest rate cut of the year on Thursday, lowering the benchmark rate by 25 basis points to 4.75%. However, after Chancellor of the Exchequer Rachel Reeves announced one of the largest fiscal easing policies in decades, investors will be watching closely to see if Bank Governor Andrew Bailey and his colleagues will signal a more cautious approach regarding future rate cuts.

The meeting of the nine members of the Monetary Policy Committee is currently significant for UK assets. The UK government's plan to increase spending and borrowing to boost investment and public services has unsettled the market. The substantial adjustment in interest rate expectations has caused the Bank of England to fall further behind the Federal Reserve and the European Central Bank in their easing cycles over the next year.

George Buckley, Chief UK Economist at Nomura Securities, stated, "The market will pay more attention to whether there are signs of a significant policy easing in December." "Higher growth and inflation may lead the Bank of England to be less dovish."

Before the budget announcement, lower-than-target inflation and a crucial slowdown in service prices increased the likelihood that the Bank of England could cut rates consecutively in November and December. Bailey also indicated that if positive news on inflation continues, the central bank might be "a bit more aggressive," which sparked market speculation.

However, after Reeves' fiscal plan shocked the market, those hopes were dashed, as her fiscal plan averages an increase of £70 billion ($90.5 billion) in spending per year. Tax increases account for just over half of the growth, with the remainder financed through additional borrowing, which is one of the causes of inflation. Although the market has largely digested the expectation of a rate cut by the Bank of England on November 7, investors believe the likelihood of another cut in December is less than 20%.

Reeves attempted to assure voters last Sunday that she would not repeat the largest tax increase plan in over 30 years. She stated, "There is no need to do that anymore," and acknowledged that it was a mistake to tell voters before the July 4 election that she would not announce new tax increases.

In an interview, she explained that she underestimated the scale of the UK's budget deficit, saying, "I was wrong on June 11, and less than a month after I said those words, I was brought into a room by senior officials from the Treasury, who explained to me the enormous black hole in public finances."

The focus now shifts to how officials on Threadneedle Street will respond to the budget. Ales Koutny, Head of International Rates at Vanguard Asset Management, stated that even whether the Bank of England will take action this week is currently in doubt, and he believes the probability of a rate cut is 50% Mark Dowding, Chief Investment Officer of RBC BlueBay Asset Management, stated, "Most of the bad news is likely already reflected in the prices now." "However, it is difficult for us to build an optimistic narrative, and we maintain a relatively pessimistic assessment of the pound's valuation."

The budget led to declines in the pound and bonds. The benchmark 10-year UK government bond yield closed at 4.45% last week, up 21 basis points from five days earlier. This marks the largest weekly increase since January. The two-year UK government bond yield rose by about 27 basis points last week. The sharp drop quickly spread to the stock market and the pound, with the pound's exchange rate against the US dollar falling for the fifth consecutive week, the longest losing streak since 2018.

Many downplayed the similarities to the market turmoil triggered by former Prime Minister Liz Truss's £45 billion unfunded tax cut plan launched in 2022. However, for the new Labour government led by Prime Minister Keir Starmer, mere comparisons are unwelcome. In July of this year, Labour won a landslide victory by promising to end the financial and political turmoil under years of Conservative leadership.

The rise in UK government bond yields last week was most pronounced on the short-term bond yield curve, in stark contrast to the significant decline in long-term bonds during Truss's tenure. This indicates that investors are concerned about how the budget will affect the Bank of England's interest rate outlook.

Modupe Adegbembo, an economist at Jefferies in London, stated, "Ultimately, the scale of the budget will be too large for the Bank of England to ignore." The scale of fiscal subsidies "increases the risk that the Bank of England will skip a rate cut in December and undermines Governor Bailey's hopes for a more aggressive approach to rate cuts."

The timing of the Monetary Policy Committee meeting on Thursday presents a significant communication challenge for Bailey, as it takes place a week after the budget announcement and just days after the US elections.

The Bank of England is expected to provide an initial assessment of how the budget will impact its forecasts. However, it remains unclear whether these measures were introduced quickly enough to be included in the new economic growth and inflation forecasts that will accompany the Bank of England's rate decision.

The Office for Budget Responsibility concluded that when the impact of the budget policy peaks in 2026, inflation will be pushed up by 0.4 percentage points. This is expected to lower living standards, whereas living standards saw a slight increase during the previous parliamentary term, despite the growth being the lowest on record

Andrew Goodwin, Chief UK Economist at Oxford Economics, stated, "All recent market fluctuations will not appear in the monetary policy report, and this is also a question of how to position the information." He added, "To be honest, this may be the worst decision-making timing they have encountered, influenced by many events."