Bank of England signals ‘earlier’ interest rate hikes for UK as Brexit looms

Bank says rate raises needed to contain ‘rising degree of excess demand’ and building domestic inflationary pressures

Interest rates can be expected to rise “somewhat earlier” according to the Bank of England, priming households and companies to expect a higher cost of borrowing in the coming years, even as the UK prepares to leave the European Union and “decouples” from the booming global economy.

The Bank, which raised interest rates for the first time in a decade in November to 0.5 per cent, kept rates on hold on Thursday, but its Monetary Policy Committee (MPC) stressed, in a hawkish emphasis, that it sees a need for monetary policy to tighten more rapidly than it did three months ago to contain a “rising degree of excess demand” and building domestic inflationary pressures.

“Were the economy to evolve broadly in line with ... projections, monetary policy would need to be tightened somewhat earlier and by a somewhat greater degree over the forecast period than anticipated [in] November,” the minutes of the MPC meeting said.

At a press conference, the Bank’s Governor, Mark Carney, appeared to endorse the shift in the view of many in financial markets, since last November, towards more rapid rate rises.

“What we don’t want to do is ... take away that natural formation of expectations because the market understands better the trade-off we’re trying to manage,” he said.

The news sent sterling up sharply against the dollar, breaking $1.40 again. Government 10-year bond yields also jumped by around eight basis points to 1.622 per cent.

However, both weakened later in the day, with sterling finishing the trading day up by only 0.25 per cent and 10-year yields at 1.591 per cent.

In November, Mr Carney had said two more rate rises were likely to be necessary by the end of 2020 to keep inflation at the official 2 per cent target.

Financial markets at that time were pricing in another rate rise late this year and another in the second half of 2020.

Now many are pricing in the next hike to happen as soon as May and for there to be at least three rate hikes over the next three years.

“Today’s communications left the impression that the MPC see a high likelihood that rates will need to rise again in May, with more to come in [the second half of 2018],” said Allan Monks of JP Morgan.

Calendar year GDP growth in 2018 is now seen by the Bank as coming in at 1.8 per cent, up from 1.6 per cent previously.

For 2019, the year of Brexit, and 2020, the GDP forecast is revised up to 1.8 per cent from 1.7 per cent previously.

These are notably stronger estimates than those from many private forecasters and also estimates from the IMF and the OECD, which expect Brexit to have a larger negative impact on the economy. The Bank’s forecasts are predicated on a “smooth adjustment” of the UK economy to leaving the EU.

However, the Bank itself stressed again that it sees concerns about Brexit weighing on firms’ investment plans, suppressing overall growth relative to where it would otherwise be. And Mr Carney recently estimated that the UK economy is about 1 per cent smaller than expected before the referendum vote and that this will rise to a relative loss of around 2 per cent by the end of 2018.

“Since the referendum on EU membership, UK GDP growth has slowed to the bottom of the range of G7 economies, having previously been at the top, and a similar pattern was observable in business investment growth,” the MPC minutes noted.

“That decoupling was also evident in asset prices.”

Nevertheless, inflation is seen by the Bank as having already peaked at around 3.1 per cent, with the impact of the slump in sterling in the wake of the Brexit vote now fading.

The MPC minutes noted the possibility that booming global growth might give the UK a larger than expected boost and that domestic wages could pick up more rapidly than it currently expects. It currently still expects average wage growth to pick up to 3 per cent this year, despite similar forecasts of an uptick frequently being proven wrong in the past.

In its annual review of the UK’s “equilibrium” rate of unemployment – the level of joblessness that the country’s economy can tolerate before inflationary pressures build – the Bank cut its estimate from 4.5 per cent to 4.25 per cent, which is roughly where it is today, implying if joblessness were to fall lower interest rates might need to go up faster.

The Bank’s judgement of total “slack” in the economy was unchanged at around 0.25 per cent. Its judgement of the UK’s potential GDP growth was also unrevised at around 1.5 per cent a year, implying that any expansion above that rate is likely to produce further excess inflationary pressure and demand further rate rises.

The Bank’s productivity growth forecast remained pessimistic, expecting growth to pick up to just 1.25 per cent this year and next. These are roughly half the rates seen before the global financial crisis. The Bank has previously said that lower business investment due to the Brexit result is likely to dampen productivity growth.