The Bank of England (BoE) has raised its main policy interest rate from 0.50% to 0.75% - its highest level since March 2009 and the first hike above the post-financial crisis level. The Bank backed away from raising rates in February owing to a significant slowdown in growth. However, data on retail sales and production have improved, which has allowed the Bank to proceed with a hike.
Brexit is the biggest risk for the UK economy and the BoE’s rate setters. We had assumed that the Bank may want to wait until November, when the likelihood of a Brexit deal would be clearer. Instead, the Bank has gambled, emphasising that the reactions of households and businesses to Brexit are more important than the outcome itself – suggesting that households and businesses may not respond.
The Bank also published its quarterly Inflation Report, which included analysis of equilibrium neutral interest rates (i.e. the level that will keep the economy neither too hot nor too cold). It concluded that the neutral rate has come down substantially since 1990 for many reasons including an ageing population, slower productivity growth and the nature of fiscal policy. In nominal terms, the BoE estimates the neutral long-term interest rate to be between 2-3%.
However, in the near-term, the neutral rate is lower due to short-term cyclical factors. We believe that this is a very dovish assessment of the current state of the economy, which may be why the pound has fallen since the announcement, while government bond yields have fallen (i.e. prices have risen).
The Bank has kept its forward guidance of slow and limited interest rate rises, with three rate hikes in three years broadly expected. We forecast two rate rises in the second half of 2019 but this is dependent on a smooth Brexit, the probability of which has been falling in recent weeks.