Andrew Bailey risks making Reeves's Budget nightmare even worse

Telegraph

3 days ago

As the Parliamentary summer break is now in full flow, most ministers will be attempting to switch off temporarily from the daily grind of governing.
The Chancellor will, however, be keeping a close eye on the Bank of England's next Monetary Policy Committee meeting this Thursday.
That is because interest rates, inflation and UK gilt yields are all key components, or 'conditioning assumptions' as they are referred to in the Office for Budget Responsibility's (OBR) economic and fiscal forecast.
This is the key forecast that determines what fiscal headroom the Chancellor will have in the autumn Budget. At the moment, economists are expecting Rachel Reeves to miss her rules by somewhere between £10bn to £30bn.
Everyone is therefore braced for further tax rises. But this figure could move significantly either up or down depending on what the Bank of England says and does on Thursday.
The market is expecting another interest rate cut this week, and one more later in the year. So unless there is a big surprise, the Treasury will obviously be hoping for, and then welcoming, some rare good news.
Most attention will therefore be on what is said about the pace of future cuts, and the Bank's forecasts for inflation, GDP and unemployment.
But the most useful comparison we can make for determining how the Budget might look is not really assessing what the Bank says versus the market's expectations. Instead, we should look at how the Bank's actions on Thursday match up to the OBR's forecasts published alongside the Spring Statement back in March.
At that point, the OBR thought that Bank Rate would average 4pc this year and then fall slightly to 3.8pc for the rest of the forecast. This would be in line with what markets are now expecting, and the interest rate cut likely on Thursday would bring the forecasts into line. So far so good for the Chancellor.
Inflation tells a different story. The OBR forecasts the consumer prices index (CPI) measure of inflation to be 3.2pc this year, and then fall to 1.9pc next year before drifting back up to target for the rest of the Parliament.
The latest figures published by the Office for National Statistics show inflation to be higher than this at 3.6pc at the moment. It is this upward pressure on inflation that would be worrying me most if I were still in the Treasury.
While it will not be enough to stop this week's rate cut, if it persists over the next few months, it may bring into doubt further cuts. In May, the Bank predicted CPI would reach 3.7pc this year, so around about what we're at now. It will be interesting to see what they say in this week's policy report.
Alongside inflation forecasts and what that might mean for future interest rate levels, Treasury officials will be watching gilt yields closely.
I developed a bit of an obsession with these when I worked there, monitoring the daily and weekly updates provided to the Chancellor on how yields compared to the OBR forecast. If they are even slightly out, this can drive up government debt interest payments, and cost billions of pounds in fiscal headroom.
Reflecting the significant amount of additional borrowing the Government has undertaken, the OBR has baked in average market gilt rates of 4.5pc this year rising to 5pc by 2028-29.
In actual fact, if you look at 10-year gilts since the February window the OBR used in their last forecast, yields have been higher than 4.5pc, reaching 4.75pc in recent months. If the market reacts to whatever the Bank says on Thursday by increasing yields still further, the Chancellor could have a major problem on her hands.
Once the formal Budget process has kicked off by the Chancellor commissioning the OBR for their economic and fiscal forecast, a window is set for various market determinants to be taken from to inform this forecast. If yields are elevated when this window happens, then the public finances will be impacted significantly.
An obvious point to state is that things can move in the opposite direction. If there are hints of a third cut to interest rates this year, then some of the fiscal issues the Chancellor is facing will be eased considerably.
But with inflation remaining higher than hoped, and the Government demonstrating a complete inability to deliver any welfare or spending cuts, the pressure on gilt yields seems pretty one way to me.
There remains a chance then that the Bank throws the Government's economic and fiscal plans into further disarray on Thursday. The short-term welcome of a rate cut could quickly be overtaken by increased worries about what else the Bank has said.
With the OBR getting ready to produce its judgment, that might be enough to spoil the Chancellor's summer holiday.