On Thursday, the Bank of England is set to announce its decision regarding a potential reduction in UK interest rates for the second time this year. Financial markets anticipate a likely cut of 0.25 percentage points, bringing the bank rate down to 4.75%. However, concerns about ongoing service sector inflation and the recent budget’s unpredictable consequences may lead the Bank to maintain current rates, awaiting further economic data.

The situation is complicated by the modest fluctuations in the UK debt and currency markets following the budget announcement, making this week’s interest rate decision more challenging than initially expected. The Bank of England faces a delicate situation where any decision could be perceived as politically motivated. A rate cut may invite accusations of compliance with a government anxious about high borrowing costs, while holding rates steady could trigger further instability in UK government borrowing costs. This represents a difficult predicament for an independent central bank.

During their August forecast, when the Bank of England announced its first rate cut of the year, economists had projected an inflation average of just 1.8% by 2026, below the 2% target, justifying the reduction in borrowing costs. Since then, inflation has performed better than anticipated, currently sitting at 1.7% annually, lower than the Bank’s forecast of 2.1%. This shift in data briefly led markets to speculate on a quicker pace of interest rate cuts, a sentiment that the Bank’s governor, Andrew Bailey, reinforced with his comments in early October.

The evolving economic landscape was altered by the budget’s expansionary public sector spending plans, prompting the Office for Budget Responsibility to revise its inflation estimate to an average of 2.3% by 2026. If Bank staff adopt this new inflation outlook reflecting increased government spending, it may pose a challenge for several members of the monetary policy committee to argue for an immediate interest rate cut.

Bailey’s task is further complicated by the committee’s divided stance. While the absence of groupthink among UK policymakers is positive, it also means that decisions could lead to personal criticism directed at the governor, especially if he has to cast a deciding vote again, as he did in August when the rate cut passed by a narrow 5-4 margin. Several committee members express concerns that core inflation, excluding volatile food and energy prices, remains uncomfortably high—a worry exacerbated by the public sector’s competitive quest for limited resources over the coming years.

The timing is especially challenging due to the upcoming contentious US election and the likelihood of a Federal Reserve interest rate cut later this week. While this may not directly affect UK inflation, the trajectory of the US dollar is crucial as it influences inflation through dollar-denominated imports into the UK economy, notably energy imports. The relatively stable UK market reaction last week was less severe compared to the aftermath of the mini-budget due to different conditions impacting inflation.

The aftermath of the mini-budget continues to trouble supporters of former Prime Minister Liz Truss, particularly concerning the Bank of England’s announcement to sell its UK government debt holdings just before the budget was revealed. Bailey is likely cautious to avoid being cast again into the political spotlight. The Bank’s commitment to its stance on selling UK government debt remains strong at a pace of £100 billion per year, despite recent spikes in government debt interest, marking a significant test of the Bank’s independence.

Ultimately, the key challenge for the Bank this week is to ensure that increased government spending does not lead to unchecked inflation in the UK. Failure to uphold this principle could severely damage the Bank’s credibility. Notably, high-profile US investors are already betting billions on the declining value of government debt, speculating that the trend of fiscal irresponsibility will lead to higher inflation, a notion linked to the historical actions of investors like Stanley Druckenmiller against the Bank of England.

So how will the Bank of England maneuver through these complexities? It could justify a cut in November by highlighting that inflation data has come in below expectations and emphasize their need to evaluate the budget’s broader implications. Many UK businesses report mixed inflationary and disinflationary effects stemming from the budget, which adds to the uncertainty of the overall economic impact. However, one thing is clear: when Rachel Reeves expressed her gratitude toward Bailey during her recent budget address, she was sincere. A skillful navigation of the upcoming days by the Bank will be invaluable to the government.

Simon French is managing director, chief economist and head of research at Panmure Liberum