RPT-ROI-BoE rate cut dances around political optics: Mike Dolan

By Mike Dolan

LONDON, Nov 4 (Reuters) - A distant prospect just a couple of weeks ago, a yearend cut in British interest rates is now more likely than not and only this month's critical government budget will stop a split Bank of England moving as soon as this week.

But there may be market fireworks either way as forecasters appear as split on the timing as the BoE's monetary council seems. And another quarter-point easing this year is still not even fully priced.

The gloomy mood around UK inflation and the interest rate horizon was punctured on October 22. Even though the headline consumer price gains for September held steady at a punchy annual 3.8% rate for the third month running, it defied expectations for a return to 4.0%.

Crucially, higher services inflation also held below consensus and later wage readings confirmed an easing of pressure. And economists now expect inflation to drop to 2.5% on average next year and to a whisker of the BoE's target in 2027.

Despite the uncertainty around fiscal repair and the annual government budget statement to be announced on November 26, the inflation report sent rate cut bets racing and shot through UK markets. Long-term government borrowing rates lurched lower, with the benchmark 10-year gilt yield hitting a low for the year at one point, and sterling plunged.

In fact, the pound's outsize move saw it fall to its lowest in more than two years against the euro and six-month lows against the dollar - even as last week's U.S. rate cut left the UK central bank with the highest interest rates of the G7.

Given the scale of those market moves though, it's a touch peculiar that the yearend rate cut is not actually fully priced yet - for all the debate about whether a cut might come this week or in December. Money markets price a one-in-three chance of a cut as soon as Thursday but only a two-thirds chance of anything coming by the December meeting.

If the back of inflation resurgence has been broken and the economy slowed as sharply in the third quarter as many suspect, then the prospect of fiscal tightening - possibly even income tax rises alongside household energy tax cuts - should surely make a fourth BoE rate cut of the year a formality.

The split nature of the BoE policymaking committee and the optics around budget may explain much of the indecision in markets as well as in the Bank's Threadneedle Street home.

CASTING VOTE

The November budget complicates the picture in two ways.

On one level, the Bank may not want to be seen to be softening the backdrop to what will be a tricky budget set-piece politically - with large fiscal holes to plug due to a variety of missed targets and a recent one-off downgrade of productivity assumptions by the main budget watchdog.

While borrowing rate assumptions in the budget may already have been flattered by markets' recent re-pricing, the BoE may not want to be seen to be softening the government's position and prefer to act in December instead when more is known.

With a split council that could well require Governor Andrew Bailey to provide the casting vote, the signal may matter more.

"Governor Bailey may be inclined to vote for a hold if he sees option value in waiting to see the outcome of the budget," Barclays' economist Jack Meaning, who expects a cut this week, said of the risks of no change.

Morgan Stanley, which still doesn't see another move at all this year, reckons the BoE committee could be split three ways this week - with five voting for no change, two for a quarter-point cut and two for a half-point move.

"The UK has a policy mix problem, and the November budget should be the first major step in resolving it," it said.

And it's not just about political optics - it's also about just what can be seen.

Clearly the extent of the fiscal squeeze and where it's applied will be important for the Bank of England. It won't know this on Thursday nor be able to include the details in its updated economic forecasts released in tandem - forecasts that may be made redundant as a result.

The combination of greater clarity on the policy mix, less controversial political timing and the advantage of having a reality check on inflation with the October CPI update all argue for the BoE to hold fire for another six weeks or so.

That said, the equivocal nature of the money market pricing means either outcome this week may pack some volatility.

The pound may have to rely more on where markets see the so-called "terminal rate" in the cycle rather than precise sequencing of the next cuts. Right now, that floor seems to settle about 3.5% through next year - that's the rate that may prove most vulnerable and most sensitive.

The opinions expressed here are those of the author, a columnist for Reuters

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