Why rising taxes could result in lower interest rates

The Chancellors' long-awaited autumn statement was delivered yesterday, which confirmed tax rises for millions of people. Some of the tax rises included allowing councils to put up council tax by more than 2 per cent annually, the Income-tax threshold being frozen for two more years up until April 2028, and allowances on dividend and capital gains slashed by over 70 per cent. The government was facing a £55bn black hole in the country's finances and said it had no option but to put taxes up.

All this has led to Office for Budget Responsibility concluding that disposal incomes of UK households would fall by 7.1 per cent over the next two years, the lowest since records began in 1956/57, and taking incomes down to 2013 levels.

Tax rises will add further pressure onto people's pockets along with UK households' cost-of-living crisis. ONS reported that Inflation in October reached 11.1 per cent, the highest since the 1980s. With energy bills soaring, food prices increasing at record pace and further tax rises, there seems to be no end to the squeeze on UK households.

However, could this mean that it leaves the Bank of England (BOE) little option but to start slowing the pace of interest rate increases or, at best, start reversing them? Morgan Stanley expects the BOEs base rate to be cut by 150 basis points before the end of next year. We discuss why this is likely to happen.  

Why was the BOE putting up interest rates at record rate?  

The Bank believes that raising interest rates will make borrowing more expensive and encourage people not to spend money, easing the pressure on the prices in the process. Another way to ensure people and businesses are spending less is to take away their money by increasing taxes, which the autumn statement provides.  

Now, admittedly the principal aim of the tax rises is to balance the books and not control inflation. However, when BOE's monetary policy committee was forecasting inflation figures and raising interest rates, it would not have been factoring in significant tax rises on the public, which could impact how further they go with interest rate increases.

Impact of Mini-Budget is no longer relevant:  

The mini-budget outlined unfunded tax cuts and spending pledges by the then Chancellor Kwasi Kwarteng led experts to predict BOE's base rate above 6 per cent by early next year. The pound reached its lowest levels against the dollar since 1985, causing further inflationary fears.

Most of the mini-budget has now been scrapped, and markets/investors have reacted positively to the new Prime Minister Rishi Sunak. It has led to experts predicting the bank's base rate now peaking at around 4.5 per cent.

Higher Unemployment and Recession:

The BOE has warned that the UK faces its most prolonged recession since records began. A recession can be defined as when a country's economy shrinks for two three-month periods or quarters. The Bank had previously expected the UK to fall into a recession by the end of this year. However, it now believes that the economy has already entered a challenging downturn this summer, which will continue next year and into the first half of 2024. The BOE believes that this will be the deepest downturn. It will be the longest since records began in the 1920s.

The BOE also expects the unemployment rate to rise to 6.5 per cent. While unemployment may be at its lowest in 50 years, it is expected to double by the end of 2025 nearly.

All of that, if correct, will leave the Bank with little option but to start putting down the interest rates to encourage consumers and businesses to spend money and invest in getting the economy moving and must review its monetary policy moving forward. This could lead to interest rates falling by the end of next year.