Starmer Gets a Gift From BOE - and a Warning on His Budget Plans

(Bloomberg) -- Prime Minister Keir Starmer’s new government groans about inheriting a fiscal mess, but it could also win the legacy of a soft landing for the UK if its own spending plans don’t send that awry.

That rosy outlook of faster-than-forecast economic growth this year was presented to the Labour administration on Thursday by the Bank of England, which accompanied its decision to cut interest rates with veiled warnings of the dangers of squandering such gifts in the Oct. 30 budget.

The prospect of tamed inflation, a healthy pace of economic expansion, along with a cheaper cost of servicing debt, offers Chancellor of the Exchequer Rachel Reeves a boon that didn’t feature in her gripes this week about the fiscal situation left by the Conservatives — a backdrop of ballooned borrowings, a massive tax burden and ailing public services.

“The boost to growth in the short term and lower rates will help them — on that they’ve been quite lucky,” said Vicky Pryce, chief economics adviser at the Centre for Economics and Business Research and a former head senior government economist. “The lower cost of borrowing and lower inflation will bring debt servicing costs down.” 

The most immediate effect of lightening the load of country’s debt burden will come from the BOE’s decision to lower the benchmark for the first time in four years by a quarter point to 5% — bringing to an end a 12-month period of the highest rates since 2008. 

That outcome reflected how the UK, in tandem with other advanced economies, has managed to avoid the worst fears of some forecasters warning that a damaging recession and rocketing unemployment might be needed to bring inflation down from its 2022 peak of 11.1%. 

Instead, the UK had a short slump at the end of last year from which it has already more than recovered, as the BOE’s forecasts showed. Officials upgraded their growth outlook for this year to 1.25% from 0.5%, while predicting that inflation will slow sustainably below 2.5% by the second half of 2025. 

Unemployment meanwhile will peak at just 4.8% in early 2026, up from 4.4% today. Financial markets expect rate cuts to keep coming, with investors anticipating borrowing costs to fall to 4% by May.

An escalation of conflicts in the Middle East and Ukraine might yet derail things. But the BOE’s narrative suggests that Labour policy could also pose a threat: Reeves mustn’t overstimulate the economy and reignite inflation, the domestic component of which remains uncomfortably high. 

“That is the balancing act that the government has to do,” said Hetal Mehta, head of economic research at St James’s Place and a former UK Treasury official.

Labour’s plans could stoke those fires if they prove too expansionary. BOE chief Andrew Bailey pointed out that the economy’s growth limit is currently estimated to be 1.5%, well below Starmer’s ambition of 2.5%. Unless Labour can lift the UK’s potential, the extra expansion the new government wants would drive up prices. 

The governor warned as much in opening comments to reporters, observing that the stronger economy over the past few months “adds to the risk that inflation could be higher than expected if we cut interest rates too much or too quickly.”

Labour’s wage plans could also pose a threat after Reeves unveiled a £10 billion ($12.7 billion) pay rise for public-sector workers on Monday. Former Prime Minister Rishi Sunak said on X after the BOE decision that such “inflation-busting public sector pay rises have put further cuts at risk.”

Bailey cautioned that on its own, the pay deal will add very little to inflation, suggesting “quite small second decimal place numbers” on a back-of-the-envelope estimate. 

But Labour wants a higher minimum wage as well, which economists believe could lead to a near 10% pay increase for private sector workers on low incomes next April — for a third consecutive year.

The governor cautioned that private sector pay has a more “immediate effect” than that of the public sector because it “feeds through directly” into the headline inflation gauge. 

An update on Thursday to its agents report of business conditions found “concerns about the potential level of the National Living Wage and its ongoing impact.” Employers were already reducing hours, increasing automation and passing on costs to cover higher wage costs, a BOE report in June showed.

Labour’s new deal for workers, which includes strong rights against dismissal on day one and ending most so-called zero-hour contracts, would in theory lead to a less flexible market and lift the equilibrium unemployment rate, Pryce added. 

For Dave Ramsden, the BOE’s deputy governor for markets, there’s evidence that the equilibrium rate is already higher than the bank thinks, which “would be negative for supply growth” and make the economy more inherently inflationary. 

Still, Bailey and the new deputy governor for monetary policy, Clare Lombardelli, stressed that there’s a lot Labour can do to increase the economy’s potential and keep price pressures at bay.

As things stand, Reeves already plans £16.4 billion of extra borrowing after claiming this week to have found a £21.9 billion black hole in the public finances — and just £5.5 billion to plug it. 

Some of that may be filled by the effects of faster growth that the BOE projects for this year. Its forecast is higher than the Office for Budget Responsibility’s 0.8% prediction, but much weaker after that. 

Too much borrowing stimulus in the October budget could raise the pressure on prices and slow the pace of rate cuts, Mehta said, noting that BOE officials who described the decision to reduce rates as “finely balanced” might think twice if the chancellor resorts to fiscal largess in October.

“For those policymakers for whom a cut was a close call, a large expansionary budget lifts the bar for cutting even higher,” she said.

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