The Bank of England is expected to keep its key interest rate unchanged on Thursday but scale back a program aimed at reducing its holdings of government bonds, a plan that is being watched more closely by markets as gilt yields continue to rise.

Near-term monetary policy path

The Bank of England cut its key interest rate from 4.25% to 4% last month, continuing its gradual pace of rate cuts that began in August 2024. This easing cycle is intended to counter the economic slowdown following a surge in inflation in 2022. Policymakers have described this pace of 25 basis point rate cuts every three months as "cautious and gradual."

If the central bank maintains its current path, it should keep interest rates unchanged at 4.25% on Thursday. However, there are signs that the central bank may hold off on cutting rates not only at this meeting, but also in November or December. To the surprise of the market, four of the nine members of the Monetary Policy Committee voted against a rate cut last month.

Bank of England Governor Andrew Bailey told lawmakers earlier this month: "There remains significant uncertainty about when and how quickly we will be able to move forward with policy."

Like the Fed, the Bank of England is struggling to balance a cooling jobs market with renewed inflation , largely due to changes in government policies such as rising water prices and new regulations on food packaging.

Quantitative tightening program expected to slow

While markets don't expect any changes to the key interest rate, they do expect the BoE to slow the pace at which it reduces its holdings of UK gilts.

Most of these bonds were purchased during the period of quantitative easing (QE) implemented after the global financial crisis, which aimed to stimulate the economy by lowering bond yields . The opposite operation - shrinking the balance sheet - is called quantitative tightening (QT).

In the 12 months to September this year, the Bank of England reduced its holdings of government bonds by a total of 100 billion pounds, a similar amount to the previous period. Since the launch of QT in early 2022, its government bond holdings have fallen from a peak of 895 billion pounds to 586 billion pounds at the end of August.

According to a Bank of England survey of market participants in August, the market expects the pace of QT to slow significantly to around 70 billion pounds. Policymakers have also signaled that they are open to adjusting the pace.

One of the reasons the decision is attracting so much attention is that UK government bond yields have been rising recently, pushing up the cost of issuing government bonds at a time when the government is trying to stick to its own fiscal rules.

The Bank of England primarily reduces its gilt holdings by not rolling over maturing bonds, but it also includes active sales. The latter increases market supply, which critics argue could drive up government borrowing costs. Notably, neither the Federal Reserve nor the European Central Bank implements QT through sales.

Even without any active sales, the Bank of England can achieve its annual reduction target of nearly 50 billion pounds by relying solely on the natural reduction of bond maturities. This approach will advance its debt reduction goals while posing little risk of market disruption , in contrast to sales operations that could impact the bond market.

Future Outlook

“I don’t think there’s an urgent need to push through a sale,” said Chris Scicluna, head of research at Daiwa Capital Markets.

The Bank of England did not specify a final target for the size of its government bond holdings, stating only that sales would be gradual and "implemented in a manner that does not disrupt the normal operation of financial markets." Considering that global bond market volatility is significantly higher than at the start of QT, a slower pace over the next year is clearly more prudent.