Interest rates ‘could fall as low as 2.75% in the next year’

The Bank of England is poised to cut interest rates much faster than investors anticipate over the next year, but policy will remain more restrictive over the long term thanks to higher public debt and population growth.
Researchers at Goldman Sachs, the Wall Street investment bank, said that the UK’s underlying interest rate had increased to 2.75 per cent since the Covid-19 pandemic, well above the negative real-terms level seen in the decade after the global financial crisis. After accounting for inflation, Goldman Sachs estimated that the real “neutral interest rate” is now 0.8 per cent, in line with its historical average since 1870.
At its current level of 5 per cent, the UK base rate “remains notably restrictive”, Goldman Sachs said, adding that the Bank of England “will ultimately lower rates more than priced by financial markets given continued progress on disinflation and recent dovish commentary”.
“We forecast sequential Bank rate cuts to a terminal rate of 2.75 per cent in November 2025 … notably below current market pricing.” Goldman Sachs said.
Although financial markets expect the Bank of England to loosen monetary policy at its next two meetings, over the long-run they think that the base rate will settle at around 3.5 per cent, much higher than Goldman Sachs’s estimates.
Inflation fell faster than the Bank of England expected over the past month to an annual rate of 1.7 per cent in September, down from 2.2 per cent in August. Services inflation, a measure of domestic price pressures that is closely monitored by the Bank of England, dropped to 4.9 per cent from 5.6 per cent.
CPI inflation is forecast to tick back up in the final months of this year thanks to an increase in the energy price cap. However, traders still anticipate 25 basis point rate reductions at the Bank of England’s November and December meetings, bringing the base rate down to 4.5 per cent.
There are a range of views on the Bank of England’s monetary policy committee — the nine-strong panel that meets every six weeks to set interest rates — on the stubbornness of inflation and how quickly to loosen monetary policy.
Andrew Bailey, the Bank’s governor, has hinted that the MPC could be more “aggressive” in lowering rates if the data confirms inflation has stabilised, while Huw Pill, the Bank’s chief economist, has expressed his preference for a gradual lowering of interest rates.
Bailey and other MPC members will participate in several panel discussions at this week’s meetings of global finance ministers at the International Monetary Fund in Washington. Their remarks are likely to provide clues on how much longer monetary policy will remain restrictive.
Goldman Sachs said: “While slow productivity growth, falling prices of capital goods and population ageing likely continued to weigh on [neutral interest rates] in the UK, sharply rising public debt and a pick-up in population growth likely pushed the other way.”
The UK’s debt-to-GDP ratio has risen from about 35 per cent in 2007 to nearly 100 per cent, its highest level since the 1960s. Over that same period the contribution of productivity growth to overall GDP growth has fallen sharply, weakening the economy’s underlying strength.
• When will interest rates go down?
Rachel Reeves, the chancellor, is expected to increase borrowing at the budget on October 30 to fund a rise in public investment spending. Analysts think that borrowing to fund investment, which can enhance growth, is unlikely to trigger a Liz Truss-style bond market rout. The former prime minister raised borrowing to finance £45 billion of tax cuts.
Policymakers are often guided by estimates of the so-called neutral interest rate, which neither stimulates growth beyond its potential and, therefore, inflation nor constrains economic activity.
It is extremely difficult to pinpoint the neutral interest rate due to the behaviour of consumers and businesses changing frequently. As such, there is a risk that central bankers either lift borrowing costs too high or keep them too low if they base their decisions on uncertain neutral interest rate assumptions.
Goldman Sachs said: “The uncertainty around these estimates is very large, however, consistent with BoE caution in placing too much weight on the neutral rate in practical policy-making.”
The Bank of England estimates the UK’s neutral rate to be somewhere around 2 per cent and 2.5 per cent.