Was the Bank of England right to hike interest rates?

4 Aug 2018

 

The Bank of England’s Monetary Policy Committee unanimously voted to increase the base rate of interest by 25 basis points to 0.75%, bringing interest rates in the UK to their highest rate since March 2009. This follows the Bank failing to raise interest rates in May, earning Governor Mark Carney the title ‘the unreliable boyfriend’.

 

Prior to the May decision, the pound hit a two-week low of 1.31 against the dollar reflecting an ongoing weakening of the pound amid Brexit fears of a no deal, and continuing dollar appreciation.

 

The pound had continued to fall when Mr Carney spoke during the press conference.

 

One of the key messages of this press conference was that the interest rates would continue to rise at a slow and gradual rate of approximately three rate increases over three years, emphasising the message that policy would ‘walk not run’.

 

The context for this is important because it explains a lot of the reasons around the decision that was announced earlier this week.

 

The Bank of England has for some time now been giving ‘forward guidance’ on its policy: predicting the general path of monetary policy over the forecast horizon. Back in November, when the BOE last raised rates, Mr Carney said ‘current market yields, which are used to condition our forecasts, incorporate two further 25 basis point increases over the next three years.’

 

The inflation report at the time showed a table of the forecasted bank rates would be around 0.7% in Q4 2018 so perhaps this is to be expected. But just because something is to be expected, does it make it right?

 

Yes and no.

 

The bank has to stay roughly in line with its forward guidance if it is to retain any credibility. A bank that says something one day but does the other will soon find that its policy becomes less effective in achieving its goals. This is important especially as the economy approaches the prospect of a no deal Brexit, and a trade war between the USA and the rest of the world.

 

But did it have to act earlier this week? Possibly not. Inflation, the bank’s main macroeconomic management task, has been falling for some time and, although the headline indicator is 0.4% above target, core inflation (inflation removing the more volatile components) is at 1.9%.

 

You could argue that the economy is reaching ‘the speed limit’ – the growth rate above which inflation begins to kick in as the output gap falls and slack reduces. This does require higher interest rates in order to reduce investment and bring spending down. However, by Mr Carney’s own admission, ‘business investment is projected to expand at an annual rate of around 3.5% over the forecast period – a subdued pace relative to past recoveries reflecting the drag from Brexit-related uncertainties.’

 

So, therefore, is a reduction in stimulus required? All answers point to probably not because Brexit is doing this job for us. Economists are already fearful it may have to roll back rates should the Brexit talks go belly up in the autumn.

 

Following the Brexit vote in 2016 the Bank of England took quick actions to cut interest rates to 0.25% and boost the quantitative easing program in order to protect the economy from short term uncertainty and volatility. This has largely been regarded as a success at a time when the governor was the only person in the political sphere who didn’t rush out the door following the vote.

 

Should the Brexit talks end in disarray it is likely the Bank will need to start to look at supporting the economy once again. Having the scope to reduce rates is important, but it’s unlikely that the most recent increase would have been felt through the transmission mechanism before rates are cut again.

 

The decision to increase interest rates is by no means a disaster. But it won’t be welcomed by businesses and households trying to weather a barrage of growing Brexit related uncertainty.

 

Realistically there is only so much the Bank can do. It is up to politicians, not central bankers, to guide the country through Brexit.

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