Many people have been baffled by the Bank of England’s decision to raise interest rates by a historically large three-quarters of a point this week, despite forecasting that the UK economy is sliding into recession. I understand this confusion, but there are three reasons why rates had to be increased.
First, the job of the Bank’s Monetary Policy Committee (MPC) is to worry about inflation, not growth. Some might like to change the MPC’s mandate, but for now it is tasked with keeping inflation at 2%. Currently inflation is over 10%, and forecast to remain high. With inflation now having spread well beyond food and energy prices, the MPC needed to act to prevent a temporary inflation shock from becoming permanent.
Second, the starting point is important. Even after the latest increase, UK interest rates of 3% remain historically low, and are firmly negative in real terms (after allowing for inflation). A more normal level for interest rates would be between 4% and 5%, roughly in line with the usual growth rate of nominal GDP. As such, monetary policy is still loose, just not as loose as it was before.
The international context is also important. Other major central banks, including the US Fed and the European Central Bank, have already raised their key rates by three-quarters of a point. The Bank of England needed to join this club in order to prevent renewed weakness in the pound, which would have added to inflation pressures.
Third, expectations are crucial. The Bank has a credibility problem after leaving interest rates too low for too long. As a result, inflation expectations are too high and need to be brought down. Put another way, sending a strong signal by hiking rates to 3% now should mean they don’t need to be raised to 6% later.
This applies to expectations for interest rates too. The Bank’s gloomy forecasts for growth and unemployment are based on market expectations for the future path of interest rates, which point to a peak of around 5¼% in 2023 Q3. This is probably too pessimistic, as some MPC members have already suggested.
However, if the Bank had raised rates by less than the three-quarter point that the markets were expecting this week, investors might have thought the MPC was going soft on inflation again, and priced in even bigger increases later as the MPC tried to catch up.
This is actually the bigger threat to mortgage rates and the housing market. Relatively few mortgages are directly linked to the Bank of England’s policy rate. Instead they depend on where interest rates are expected to be over the life of the loan. Again, a bigger rate increase now could therefore help to keep mortgage costs down.
It may not feel like it, but the Bank’s decision is therefore the right one. The alternative of leaving interest rates lower for longer might mean faster growth in the short term, but also higher inflation, higher interest rates, more expensive mortgages and lower growth further ahead.
The Bank probably still has some more work to do. For what it’s worth, my own guess is that UK interest rates will only need to rise to the bottom of the 4% to 5% range, given the additional headwinds from the weakening in the global economy and from the likely squeeze on tax and spending in the November Budget. But the MPC would not be doing anyone any favours by taking too long to get there.
This article was first published in the i on 4th November 2022
Postscript (noon 4th November). In the event, the markets have interpreted the Bank’s statement as dovish, focusing on the signals that interest rates will not need to rise as much as expected. This, combined with relatively hawkish comments from the Fed Chair, Jay Powell, weakened the pound against the dollar. But it has also eased the pressure on mortgage rates, which matters far more than the hike in the Bank rate itself.
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