The Bank of England keeps interest rates unchanged; balance sheet reduction is more than expected

According to Zhitong Finance APP, the Bank of England announced on Thursday that it would keep its benchmark interest rate unchanged at 3.75%, in line with widespread market expectations. The Bank of England warned that if tensions in the Middle East lead to increased inflationary pressure, a rate hike may be necessary. The Bank abandoned its plan to sell long-term UK government bonds and said it would gradually reduce its £488 billion ($653 billion) debt portfolio by September 2034.

Six rate-setters, including Governor Andrew Bailey, supported holding the rate steady, while Catherine Mann, Megan Greene, and Huw Pill voted for a 25 basis point increase. The division within the Monetary Policy Committee remains the same as in the July meeting.

In his prepared remarks, Bailey said that the global energy shock has so far had limited effects on UK prices and wages. “But the longer this volatility persists, the greater the impact on inflation, and the more likely we are to need to raise Bank Rate,” he added.

Traders reduced their bets on Bank of England rate hikes, fully pricing in one increase by year-end with a 50% likelihood of another. UK government bonds rallied, particularly longer-term bonds, with 30-year yields falling 5 basis points to 5.80%. The pound pared gains against the dollar to trade at 1.3374.

The escalation of US-Iran tensions complicates the Bank of England's decision-making process. Surging oil and natural gas prices have pushed fuel costs higher, bringing further challenges for UK households as the energy price cap is reset in the new year.

The Bank of England maintained its core guidance in the September meeting minutes, stating it is “prepared to act,” and added that risks are “skewed to the upside” and higher than in July. The minutes noted that price pressures are expected to rise in the coming months. Indirect effects not yet visible in the UK economy may be “delayed rather than diminished.”

The Bank currently expects inflation at the beginning of next year to be double its 2% target, and has raised its third-quarter GDP growth forecast to 0.4%.

The Bank of England’s decision to hold rates comes as other central banks continue to tighten policy. The Federal Reserve raised rates on Wednesday, while the European Central Bank imposed its second rate hike of the year last week, by 25 basis points.

David Rees, Global Chief Economist at Schroders Investment, said: “UK domestic inflation is under control, wage growth is slowing, and the unemployment rate is close to 5%, indicating significant weakness in the labor market. The current economic situation does not require a rate hike.” He added, “The bigger risk lies in fiscal policy.”

Major QT Adjustment: Abandoning Long-term Gilt Sales, Balance Sheet Reduction Slowed More Than Expected

However, for bond investors, the focus is more on the Bank of England’s quantitative tightening (QT) plans for the coming year rather than Thursday’s rate decision. The Bank made a major adjustment to its QT strategy, announcing it will abandon selling long-term gilts and will gradually reduce its £488 billion (about $650 billion) debt portfolio by 2034.

According to proposals not yet finalized, the Bank will retain £120 billion of gilts maturing in 2049 or later, aligning these with future banknote issuance. Another £222 billion of gilts maturing by 2035 will be allowed to mature naturally, while the remaining £146 billion maturing between 2035 and 2049 will be sold at a rate of £20 billion a year, potentially directly to the government via the Debt Management Office (DMO).

In a letter to Chancellor of the Exchequer John Healey, Bailey indicated that this arrangement “preserves the independence of monetary policy” and would “maximize value for money throughout the life of the plan by minimizing cost and risk.”

All planned QT auctions will be paused until next April to finalize terms for sales to the DMO. The move aims to avoid competition with government bond issuance, thus alleviating short-term pressure on gilt yields. However, the arrangement may slightly erode Healey's fiscal buffer.

The market greeted the news positively, with longer-term gilts leading gains and 30-year yields down 5 basis points to 5.80%. The swap spread (a gauge of bond supply sensitivity) held steady at 68 basis points.

This new QT program comes at a time when its management is under intense criticism. Since balance sheet reduction began in 2022, QT has generated losses totaling £110 billion, borne by taxpayers, after previously posting £124 billion in profits. Bank of England documents indicate that further losses of £100 billion are expected.

According to the new proposal, the portfolio will shrink at an average annual rate of £46 billion, of which £20 billion is through active sales. The market had previously anticipated the Bank of England would slow its runoff to £50 billion per year over the next 12 months (from October), down from £70 billion in the previous two years and lower still than £100 billion in the year before that.

The Treasury and the Bank of England have been working on this arrangement for almost a year, but final terms have not yet been agreed. The Bank intends to sell gilts directly to the DMO, which can then cancel these bonds and issue larger volumes to better match market demand. The final decision lies with the Treasury. The Bank of England stated that £120 billion of long-term gilts will be held as asset backing for cash in circulation, and these count as liabilities of the Bank.