Bank of England keeps interest rates unchanged, scales back balance sheet reduction more than expected.

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 it may need to raise interest rates if the Middle East conflict intensifies inflationary pressures. The Bank of England abandoned its plan to sell long-dated 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 keeping rates unchanged, while Catherine Mann, Megan Greene and Huw Pill voted in favor of a 25 basis point increase. The split on the Bank of England's Monetary Policy Committee was the same as at the July meeting. In prepared remarks, Bailey said the global energy shock has so far had a limited impact on UK prices and wages. "But the longer this volatility persists, the greater the impact on inflation, and the more likely it is that we will need to raise the central bank rate," he added. Traders reduced their bets on Bank of England rate hikes, fully pricing in one increase by the end of the year and a 50% chance of another. UK government bonds rose, led by long-dated debt, with the 30-year yield falling 5 basis points to 5.80%. Sterling erased gains against the dollar to trade at 1.3374. The escalation of the US-Iran conflict has made the Bank of England's decision-making more difficult. Oil and gas prices have soared, pushing up fuel costs and creating numerous problems for UK households when the energy price cap resets in the new year. In the minutes of its September meeting, the Bank of England kept its core guidance unchanged, saying it was "ready to act," while adding that risks were "skewed to the upside," and more so than in July. The minutes said price pressures were expected to increase in the coming months. Indirect effects that have not yet appeared in the UK economy may be "delayed rather than diminished." The Bank of England now expects inflation to reach twice its 2% target early next year and raised its third-quarter GDP growth forecast to 0.4%. The Bank of England's decision to keep rates unchanged came as other central banks tightened monetary policy. The Federal Reserve raised rates on Wednesday, and the European Central Bank also delivered its second rate hike of the year last week, increasing by 25 basis points. David Rees, head of global economics at Schroders, said: "UK domestic inflation is under control, wage growth is decelerating, and unemployment is near 5%, indicating significant slack in the labor market. Current economic conditions do not require higher interest rates." He added: "The bigger risk lies in fiscal policy." Major QT overhaul: Abandons long-dated gilt sales, balance sheet reduction slows more than expected For bond investors, however, the focus was more on the Bank of England's quantitative tightening (QT) plan for the coming year than on Thursday's rate decision. The Bank of England made a major adjustment to its QT plan, announcing it would abandon sales of long-dated government bonds and planning to gradually reduce its 488 billion (about $650 billion) debt portfolio by 2034. Under proposals that have not yet been finalized, the Bank of England will retain 120 billion of government bonds maturing in 2049 or later, matching them against future banknote issuance. Another 222 billion of government bonds maturing before 2035 will be allowed to run off naturally, while the remaining 146 billion maturing between 2035 and 2049 will be sold at a pace of 20 billion per year, and may be sold directly to the government through the Debt Management Office (DMO). In a letter to UK Chancellor John Healey, Bailey said the arrangement "preserves the independence of monetary policy" and would "maximize value for money over the life of the plan by minimizing costs and risks." All planned QT auctions will be paused until April next year to allow terms for sales to the DMO to be finalized. The move is intended to avoid competing with government bond issuance, thereby easing short-term pressure on gilt yields. However, the arrangement may slightly erode Healey's fiscal headroom. Markets reacted positively, with long-dated UK government bonds leading gains and the 30-year yield falling 5 basis points to 5.80%. The premium to swap rates, a measure of sensitivity to future bond supply, held steady at 68 basis points. The new QT approach comes as the way the program has been managed faces intense criticism. Since balance sheet reduction began in 2022, QT has accumulated 110 billion of losses borne by taxpayers, after previously generating 124 billion in profits. Bank of England documents show a further 100 billion of losses are expected. Under the new proposals, the portfolio will shrink by an average of 46 billion per year, of which 20 billion will be active sales. Markets had previously expected the Bank of England to slow the pace of balance sheet reduction to 50 billion per year over the 12 months starting in October, down from 70 billion in the previous two years and 100 billion the year before that. The UK Treasury and the central bank have worked on the arrangement for nearly a year, but final terms have not yet been reached. The Bank of England plans to sell government bonds directly to the DMO, which could then cancel them and issue larger amounts of debt to better meet market demand. The final decision rests with the UK Treasury. The Bank of England said the 120 billion of long-dated government bonds will be retained as asset backing for cash in circulation, which is a liability of the central bank.