It is good to start for once with some praise for the Bank of England.
After the Hallowe’en Budget in the UK, and the fireworks of election night in the US, the Bank’s Monetary Policy Committee (MPC) helped to calm the nerves by delivering the expected quarter point cut in interest rates to 4.75pc on Thursday.
The MPC also signalled that, unless there are any fresh surprises, rates would continue to be lowered “gradually”. This time, the Bank’s communications were clear and reassuring.
However, the MPC acknowledged that the economic outlook and the path for interest rates were highly uncertain, not least because of the fallout from Rachel Reeves’ first Budget.
The Bank’s staff economists echoed the Office for Budget Responsibility in forecasting that the additional spending and borrowing in the Budget will provide a temporary boost to growth and inflation. In turn, this implies that interest rates will be higher for longer.
It was some comfort, then, that the Bank still forecast that inflation will return to the 2pc target over the medium term – even based on market expectations that official interest rates will be cut (“gradually”) to 3.75pc by the end of next year.
Moreover, that would not be a bad place to end up. Interest rates of around 4pc would be appropriate for an economy growing by 2pc and with inflation of 2pc.
But there are several ways in which this soft landing could be disrupted, resulting either in much higher rates or, potentially, much lower.
The immediate threat has already been signalled by the adverse reaction to the Budget in the bond markets.
The OBR had assumed that official interest rates and bond yields would both be a quarter point higher than otherwise over the forecast period as a result of the Budget measures.
Any impact greater than this – if sustained – would therefore blow the public finances off course.
Unfortunately, yields on UK government bonds have already risen a lot further. In particular, the OBR was forecasting that five-year gilt yields would average 3.7pc in the fourth quarter of this year and 4pc between 2025 and 2030.
In fact, they have already hit 4.4pc.
Investors are not just worried the additional spending in the Budget will boost inflation and hence slow the pace of rate cuts.
They are also worried that the additional taxes will not raise as much money as expected, and that the additional borrowing will mean that yields have to rise to attract enough buyers for the additional bonds that will have to be issued.
In short, there are fears of a lasting “risk premium” in gilts.
Admittedly, not all the recent rise in the cost of UK government borrowing is due to events in the UK.
Yields have also risen sharply in the US, partly in anticipation of more fiscal stimulus and higher inflation under a second Trump Presidency, given the threat of large unfunded tax cuts and tariff increases.
Other economies whose borrowing costs tend to track those of the US, notably Australia, have seen similar rises.
Nonetheless, whatever is behind it, any increase in interest rates will hurt.
The OBR’s ready reckoner suggests that even just a half-point rise in bond yields, official rates and inflation could together add about £10 billion to annual debt servicing costs – potentially requiring even more tax rises to fill the gap.
Sentiment also matters for other markets. It is not widely understood that the current level of official interest rates is often much less important than where they are expected to head in future.
This is particularly the case for fixed-rate mortgages, where the cost depends on what is expected to happen to official rates over the life of the fix, typically the next two or five years.
The problem here is that the mortgage market has already priced in further “gradual” cuts from the Bank of England.
Indeed, the OBR expects mortgage rates to trend higher from here, and more than it did at the time of the March Budget.
The upshot is that borrowing costs may now be higher for longer in the wider economy, even if the MPC keeps cutting.
But there is another scenario in which rates could still fall more quickly than expected – though it is not an attractive one.
The increases in taxes and other business costs in the Budget could dampen growth more than they boost inflation, meaning that rates have to be cut more aggressively.
As it is, official rates are still higher than they need to be to continue bearing down on inflation, especially given that the full effects of past increases have still to feed through, and the Bank is also tightening policy by running down its holdings of government bonds.
The Budget has already knocked household and business sentiment – the all important “animal spirits” – even before the main tax measures take effect.
A trio of snap polls (by YouGov, Savanta and BMG Research) all found that many more people expected the overall package to be negative both for the economy and for their own finances than positive.
Consumer confidence was already wobbling in anticipation of a tight Budget, but the tax increases were larger and broader than most had expected.
Business expectations for activity in the year ahead have softened across the board.
This verdict is not necessarily right or fair, of course, and it is worth remembering that the recent activity data have generally been better than expected despite weaker confidence.
But there is a real risk that mounting worries about the economic outlook could prove to be self-fulfilling.
The Bank acknowledged the uncertainties here, implying rates could still be cut more quickly. But whether rates are lower than expected because of a slump in economic activity, or higher because of a surge in inflation, neither outcome would be much to cheer.
Hopefully, the MPC will be more nimble in future. But the Budget has just made their job even harder.
Julian Jessop is an independent economist