Bank of England raises rates despite inflation optimism

The Bank of England’s monetary policy committee voted to increase interest rates by 25 basis points on Thursday afternoon. The move marked the central bank’s twelfth consecutive hike, and takes the UK bank rate to 4.5 per cent –  the highest level since October 2008.

Though the move was widely anticipated by markets and economists, the Bank’s next step is less clear. Though seven members of the rate-setting committee voted for the 25 basis point hike, two voted for a pause. 

In a statement released after the meeting, the Bank said that its next decision would be data driven, noting that “if there were to be evidence of more persistent [inflationary] pressures, then further tightening in monetary policy would be required”.

Brighter forecasts 

Thursday’s hike came against a backdrop of persistently high inflation, but better than expected economic growth. March’s inflation figure came in at an eye-watering 10.1 per cent, a figure that Berenberg Senior Economist, Kallum Pickering, said had to “virtually guarantee” a further hike this week. 

The Bank nevertheless expects UK inflation to start to fall rapidly. Forecasts released after the meeting suggest that inflation will settle at 1.1 per cent by 2025, undershooting the Bank’s 2 per cent target. Analysts from Pantheon Macroeconomics noted earlier in the week that below-target forecasts could “nudge markets that the MPC thinks it likely won’t need to hike Bank Rate again”. 

The Bank also set out a more optimistic outlook for UK growth, thanks in part to falling wholesale energy prices and stronger global growth. The last time the Bank published forecasts in February, it expected a five-quarter recession starting in Q1 of this year. It now expects the UK economy to dodge a contraction, and return to 0.9 per cent growth by 2024. 

Bank communication in the spotlight

With Thursday’s 25 basis point hike so roundly anticipated, bank communications were under the spotlight. Matthew Ryan, head of market strategy at global financial services firm Ebury said before the meeting that market reaction would be determined by “the tone in MPC communications, its macroeconomic projections, and the actual vote split” as a result. 

In a statement released after the meeting, the Bank gave few clues about where rates would go next. The committee said that it was “continuing to address the risk of more persistent strength in domestic price and wage setting”, but added that “the pace at which domestic inflationary pressures ease will depend on the evolution of the economy, including the impact of the significant increases in Bank Rate so far”. 

Following the meeting, market pricing indicated that the BoE would raise interest rates to a peak of close to 5 per cent. The data implies that traders expect the first rate cuts later in the year, and crucially, the Bank did not attempt to push back against financial market expectations. 

Is this the end of rate hikes? 

The latest hike came in the wake of last week’s 25 basis point rate rises from the Federal Reserve and the European Central Bank. Though the central banks stopped short of announcing a change of direction, the moves were widely interpreted by economists as a signal that rate hikes were coming towards an end.

But judging whether we have reached the end of the tightening cycle will be difficult. Investec economist, Ellie Henderson said that “what is clear is that the days of successive interest rate hikes in this economic cycle are limited, but the exact endpoint is clouded with uncertainties”.

In reality, much will depend on the future path of inflation. Frances Haque, Santander chief economist, said that though CPI  growth should fall significantly, inflation could remain sticky in the months ahead. She said that “the increase in rates has not fully passed through the economy and the arguments around waiting for the full effects to emerge is gaining ground”. 

“The build-up of pressure from such rate rises has a habit of suddenly turning, so a pause now might well be the appropriate response, with the option of tightening further if core inflation sticks around”, Haque added. 

But there is little consensus amongst economists. Earlier this week, Bank of America analysts said that “the UK has one of the most severe persistent inflation problems among developed market economies”. We could see more limited rate cuts than markets anticipate next year as a result. 

Following the BoE’s decision, the FTSE 100 largely flat, losing 0.31 per cent on the day. The pound edged up against the dollar, gaining 0.3 per cent on the day at $1.26. Yields on interest rate sensitive two-year gilts moved slightly, falling by 0.02 percentage points to 3.8 per cent.