Bank of England gets it right

The Bank of England’s Monetary Policy Committee has decided that continued inaction this month in the face of soaring inflation would do far more damage in the longer term than a small increase in UK interest rates now.

The Bank has also ended the expansionary phase of ‘quantitative easing’. The MPC voted to maintain the stock of bond purchases, financed by money printing, at the level which has already been reached. This means that there are currently no plans to do any more QE in 2022.

The 0.15 percentage point increase in the Bank’s official interest rate, to 0.25%, still leaves borrowing costs at historically low levels. UK interest rates were 0.75% before the pandemic stuck, but economic activity and employment have now largely recovered.

Most importantly, inflation is now well above the 2% target and has consistently overshot the Bank’s forecasts. The MPC’s main job is to worry about inflation and the moves today should go some way towards restoring the credibility of the monetary policy framework. This will therefore help to keep inflation in check over the longer term.

The MPC acknowledged the downside risks to economic activity from Omicron, but the majority of members put more weight on the additional upside risks to inflation. This is surely correct as well.

If the economy does need further support in the short term, this should come from fiscal measures targeted at the sectors most at risk. An extended period of ultra-loose monetary policy might just add to economy-wide price pressures, and require bigger increases in interest rates in future to bring inflation back under control.

The financial markets have largely taken the news in their stride: small rises in UK government bond yields (but not much more than in other markets), small fall in equity prices (but still up on the day), and a small jump in sterling (but less than some might expect).

This makes sense. While the precise timing of the Bank’s moves may have taken some (not all!) by surprise, we knew rate rises were coming, the rationale is clear, other central banks are heading in the same direction, and the willingness to hike despite Omicron can be seen as a vote of confidence in the UK economy.

Looking forward, I continue to expect the Bank to return rates to 0.75% next year. This should not be a gamechanger for markets, especially as interest rates would still be low (especially real rates). Context is also important: central banks are only changing tack because economic growth and inflation have been stronger than expected.

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