MNI INTERVIEW: BOE Dec Cut Chances Overestimated - Saunders

Markets are significantly overestimating the chance of a December cut, former Bank of England Monetary Policy Committee member Michael Saunders told MNI, noting that the effect of any fiscal tightening in the Nov 26 budget is likely to be deferred and the MPC will not receive key agents’ pay survey data before February.

“I think the chance that they cut rates in December is much lower than the markets are pricing, because I suspect the fiscal measures will not be shaped in a way that is heavily front-loaded,” Michael Saunders said in a phone interview.

If fiscal tightening is not front-loaded, the MPC will judge it “can afford to wait” to assess its impact, he added. The BOE announces rate decisions on Nov 6 and Dec 18, with markets pricing in a roughly 70% chance of a cut by the end of the year.

“We've got plenty of space to cut interest rates. And if the downside effect on the economy of some of these fiscal measures is not that big, then fine, you don't need to use all the monetary policy space, but it's there if you need it.”

FISCAL CONSOLIDATION OPTIONS

The budget is expected to involve sizeable fiscal consolidation through tax rises to meet Chancellor of the Exchequer Rachel Reeves’ self-imposed fiscal rules. Saunders, now at Oxford Economics, expects the budget to deliver 90% of its tightening between 2024/2025 and 2029/2030 through an increase in the tax/GDP ratio, though he warned against this.

International data shows a fiscal consolidation using tax hikes is normally less effective than one using spending cuts, he said, as “the cumulative effect of large tax hikes tends to trigger a bigger behavioural response.” (See MNI INTERVIEW: Uncertain Fiscal Boost From Taxing UK Pensions)

The gain in revenue from increases to multiple taxes is harder to predict than that from an increase to income tax, and raises the risk of a larger hit to growth, Saunders said. The Labour Party’s manifesto, however, ruled out hiking income tax.

A large number of small tax changes “either leads to less revenue than you would have hoped, or more of an adverse effect on potential growth,” he said.

“You've got more evidence on the effects of changing main tax rates by a percent or two, because that has happened in more previous times,” he said, while “you’ve got little evidence on the cumulative effect of loads of small tax changes.”

Changes to major taxes would “ensure that markets recognise that the government still has plenty of options to ensure the public finance is on a sustainable path.”

Treasury Minister Torsten Bell has detailed a variety of potential tax changes, but Saunders said the catch was that the list is all-inclusive.

"Once your work your way down that list, you're done. There is nothing else,” he warned. “The more of them you use up, the fewer you have remaining as fiscal options for the future. Therefore, you're closer to your limits of potential revenue-raising measures. You are literally scraping the barrel," Saunders said.

VIRTUOUS CIRCLE

Still, substantial fiscal tightening would produce “a second-round benefit by lowering debt service costs of the government, which would improve fiscal space still further,” Saunders said. It would reduce term premia on gilts, and lower expectations for Bank Rate, which would further improve the fiscal outlook, he added. (See MNI INTERVIEW: UK Debt Stabilisation Insufficient - NIESR Head)

“Rather than a doom loop, you're in a virtuous circle,” he said, and it would not affect monetary conditions enough to weigh against easing.

Even so, the resulting economic boost would be limited.

If the budget causes "20- to 30-year yields to fall, that's great for the fiscal position. But, actually, the boost of the economy is not that large," Saunders said.