Economics

Bank of England raises interest rates but are there more hikes to come?

Despite a sluggish economy, the central bank is worried about rising inflation pressures.

02/11/2017

Azad Zangana

Azad Zangana

Senior European Economist and Strategist

The Bank of England’s (BoE) monetary policy committee (MPC) has raised interest rates for the first time since November 2007, in a move that has been well-flagged in recent months.

The policy interest rate has been raised from a record low of 0.25% back to 0.50%, where it sat for most of the past decade until the Bank’s decision to cut just after the Brexit referendum. The Bank also announced that it has not changed its quantitative easing policy.

Inflation has risen sharply

Since the Brexit referendum, the economy has performed better than expected, while inflation has risen sharply, largely due to the depreciation in sterling. With inflation at 3%, any further rise will force the BoE to write to the Chancellor of the Exchequer to explain the circumstances of the overshoot, and what it is doing to return inflation back to target.

The MPC believes that the economy’s ability to grow has been hit by Brexit. As a result, it estimates that the slack that remains in the economy is limited.

Unemployment is at a 42-year low, which should cause wages to accelerate in the near future. Of course, the BoE has predicted big increases in wages in the past, and has so far been badly wrong.

The MPC was not unanimous in backing the rise in interest rates. Two of the nine member committee voted against the increase, highlighting that substantial risks remain for the economy.

Inflation forecasts imply further rate hikes

While many are asking whether this interest rate rise will have much of a negative impact on growth, the more important question is whether the MPC sees this as a one-off rise, or whether this is the first of many.

The Bank publishes an inflation forecast which is conditioned by a profile of future interest rates derived by market pricing. This path shows two interest rate rises over the next three years.

However, as inflation is above 2% at the end of the forecast, this should be seen as a signal from the BoE that more rate rises than the two assumed at present may be required.

This first rate rise will undoubtedly burden those that are struggling to make ends meet, but for the vast majority, it will have a small impact. That said, it is unhelpful when wages are struggling to keep up with inflation, and when growth is slowing.

Markets not expecting another rise soon

The initial response to today’s announcement in markets is interesting. The pound has fallen by more than 1% against both the US dollar and euro, while the market-assumed date for the next rise in interest rates has been pushed back from Q3/Q4 2018 to Q1 2019 – suggesting that investors do not believe the MPC will have the conviction to hike again anytime soon.

The UK economy has gone from being one of the best performing economies in the advanced world last year to the second weakest in the G20 last quarter (only ahead of crisis-ridden Brazil).

This rate rise could go down in history as the Bank of England’s “Trichet moment” – possibly repeating the European Central Bank’s perceived mistake in 2011.