Bank of England governor Andrew Bailey on Thursday insisted the central bank had no choice but to raise interest rates, saying if it had done nothing, it would risk inflation staying persistently too high.
This was the BoE putting its new slogan that it is “in the price stability business” into action, given consumer price inflation is currently running at a decade high of 5.1 per cent, compared with the central bank’s target of 2 per cent.
But the first interest rate rise in more than three years posed two questions: why tighten monetary policy now rather than early next year, when economic uncertainty unleashed by the new Omicron coronavirus variant may have eased? And what impact will a tiny 0.15 percentage point increase in rates, to 0.25 per cent, have on the economic recovery and people’s lives?
With the BoE Monetary Policy Committee having surprised financial markets and economists for two consecutive meetings, by holding rates in November and then raising them on Thursday, Bailey will be aware that he is seen as an unpredictable communicator on monetary policy.
Allan Monks, economist at JPMorgan, summarised the MPC rate rise as the “right decision, wrong month”, saying the action would have made much more sense in November, when inflation was already surging and Omicron was not on the radar.
The BoE rejected such criticisms. Instead its reasoning can be summarised as it responding to three “Ds” that have transpired over the past six weeks.
First, new data suggests the inflationary threat has intensified. Second, new deliberations by the MPC’s nine members show them concerned about the prospect of persistent price growth. Third, new discussions with companies have highlighted the need to act swiftly.
The data highlighted by the BoE mostly came from the labour market, where MPC members noted there was “little sign” the end of the government’s furlough scheme in September had weakened demand for workers, solidifying their view that “the labour market is tight and has continued to tighten”.
The MPC’s persistent underestimation of inflation this year has also concentrated minds, with members now expecting the annual rate of price growth to peak now at about 6 per cent, compared with 4 per cent in their forecast four months ago.
This has caused a change in deliberations on the MPC. Instead of seeking to explain away high price growth as “transitory” or “temporary”, members have accepted that above target inflation is likely to persist.
And while members still expect the rate of inflation to fall back in the second half of 2022, they now worry that companies and workers will respond to jumps in costs by raising prices and increasing wage demands.
The MPC now expects goods price inflation to remain “well above” pre-pandemic levels in the months ahead. It anticipates services inflation to “increase somewhat further”, and food prices to “rise further, reflecting cost increases over recent months”.
One of the things that has alarmed MPC members most has been the regular discussions it has with businesses across the UK, including via its survey of decision makers in the corporate world.
These all suggested that inflation was likely to be persistent, with companies reporting they have already increased their prices by almost 5 per cent over the past year, and are planning to raise them by another 4.2 per cent by November 2022.
The BoE survey of decision makers also suggested almost 60 per cent of companies were finding it “much harder than normal to recruit” employees. The greatest pressures were in sectors with well known labour shortages: hospitality, transport and logistics.
If the three Ds explained the MPC’s new concern about persistent inflation and its members’ eight to one vote to raise rates, the 0.15 percentage point increase appears small compared with the problems the BoE has identified.
Higher interest rates normally work by seeking to restrain company and household spending, partly by increasing the cost of borrowing, thereby lowering demand and bringing it back in line with the output the economy can supply without prices going up excessively.
An interest rate of 0.25 per cent will not change much directly, given the vast majority of mortgage borrowers now have fixed rate loans. Charles Roe, director of mortgages at UK Finance, a trade body, said: “Over 74 per cent of mortgage customers are on a fixed rate product and will see no immediate change to their mortgage payments.”
The rate rise was therefore designed more as a warning shot to companies and workers, so that they do not bake higher inflation into pricing and wage decisions over the months ahead.
To discourage people from thinking the BoE will allow high inflation to persist, the MPC said there was a “strong case” for immediate tightening of monetary policy along with further “modest” increases in rates to come “in order to maintain price stability in the medium term”.
“Maintaining the current monetary policy stance when CPI inflation was materially above the 2 per cent target . . . might cause medium-term inflation expectations to drift up further,” it added.
George Buckley, economist at Nomura, who correctly predicted the BoE would act on Thursday, said the signal on rates was much more important than the amount by which they had risen.
“The bank clearly did not want to be in a position in two to three months’ time, whereby inflation has risen further, the virus is once again in retreat, yet it had failed to get policy rates off the ground,” he added.