Investors are betting that the Bank of England will raise interest rates to their highest level since the global financial crisis within the next year, with the first move potentially coming this week as policymakers seek to contain surging inflation.
A rate increase would put the BoE in the vanguard of a global shift towards tighter monetary policy, with the US Federal Reserve expected to start tapering its asset purchase programme this week. Canada’s central bank ended its bond-buying programme abruptly last week and signalled it too could raise interest rates soon to combat rising price pressures.
Market pricing suggests UK interest rates are set to rise above 1 per cent by the end of 2022, reaching their highest level since 2009, with an initial rise of 15 basis points on Thursday taking the benchmark rate to 0.25 per cent. Almost half of UK households also expect borrowing costs to rise within the next three months, according to a survey by the research group IHS Markit.
Philip Shaw, economist at Investec, said a majority on the nine-member Monetary Policy Committee would be likely to feel “that there is relatively little to lose by raising rates by 15bp at this stage, but that its credibility is at stake should rising inflation prove to be more than transitory”.
But while he is among analysts who have brought forward their forecasts for rate increases, others say traders may be overestimating the chances of an immediate move, with the MPC split and Thursday’s decision set to be finely balanced.
“The outcome of November’s meeting is more unpredictable than any since the pandemic began,” said Andrew Goodwin, at the consultancy Oxford Economics.
Andrew Bailey, the BoE governor, fuelled market expectations when he told a panel discussion a fortnight ago that policymakers would “have to act” if the surge in energy prices led people to expect higher inflation in the medium term — although he gave no indication of timing.
Sir Dave Ramsden, deputy governor for markets and banking, and Michael Saunders, an external MPC member, have also struck a hawkish note. Meanwhile, Huw Pill, the BoE’s new chief economist, told the Financial Times that inflation could reach 5 per cent within months, making it “a very uncomfortable place for a central bank with an inflation target of 2 per cent to be”.
This represents “a much more hawkish shift in rhetoric than other central banks”, according to Paul Hollingsworth, chief European economist at BNP Paribas, noting that in contrast with the Fed or European Central Bank, the BoE did not need to compensate for past undershoots of its inflation target.
He did not expect the BoE to raise rates as fast or as far as market pricing suggested, but said that the MPC might still want to tighten policy “earlier rather than later” because data revisions showed gross domestic product was closer to its pre-pandemic level than previously thought; inflation had surprised on the upside; and the MPC might now suffer a “hit to credibility” if it failed to follow up on its hints.
Paul Dales, at the consultancy Capital Economics, saw a “high chance” of a rate rise on Thursday, allowing the MPC to show it meant business before the next data release revealed inflation at double its 2 per cent target. The extra spending announced in last week’s Budget, a net fiscal giveaway, could also “nudge the MPC towards an earlier tightening,” he said.
But some MPC members are likely to favour waiting.
Catherine Mann, an external member, has argued that the recent rise in market interest rates has already led to tighter financial conditions, giving policymakers room to wait. Silvana Tenreyro, another external member, has argued that supply chain pressures could prove shortlived and an early rate rise self-defeating.
Other MPC members have not commented in public recently, but Jonathan Haskel, an external member, has previously been one of the committee’s more dovish voices. This means that the two remaining members, deputy governors Ben Broadbent and Sir Jon Cunliffe, could swing the vote.
Analysts say there are good arguments for the MPC to take a more cautious approach, with the UK’s recovery losing momentum, and consumer confidence wavering in the face of rising energy bills and taxes.
The BoE will publish new economic forecasts alongside this week’s decision, including its annual assessment of the supply side of the economy. But it will be missing key information: policymakers have signalled that they would like to see October’s labour market data, showing any fallout from furlough’s end, before acting — figures they will only receive just before December’s meeting.
Goodwin said he expected the MPC to delay action until February, to “allow a proper assessment of the furlough scheme’s end and avoid adding to the considerable cost-of-living challenges facing households over the winter”. Other analysts said it would make sense to wait at least until December, to avoid the oddity of tightening policy through rate rises while the BoE’s asset purchase programme, which is due to wind up at the end of the year, was still running.
More important than the timing of the first rate rise, though, is the extent and pace of any further moves. Here, most analysts think market expectations go further than the evidence justifies.
Dales said this week could mark “the start of a run of rate hikes”, but that once the benchmark rate reached 0.5 per cent — the point at which the BoE has said it could start reducing the size of its balance sheet — “the desire to raise rates further may wane”.
James Smith, economist at ING, said traders were “well ahead of themselves” in expecting interest rates to reach levels not seen since the financial crash. If the BoE’s new forecasts showed inflation falling below target in the medium term, based on these expectations, it would be “an implicit hint that market pricing has gone too far.”
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