A steep hike in interest rates would be a mistake

The Bank of England’s monetary policy committee (MPC) has been sending out signals about the need for hikes in interest rates to control inflation.

Unsurprisingly the financial markets have latched on to this, ratcheting up their expectations for the Bank’s base interest rate to hit 1.6 per cent by the end of the year, implying as many as four more quarter-point hikes from the current 0.5 per cent level.

It is easy to see why. Not only was the MPC unanimous about the need for a rate rise last month, but four of the nine members wanted a half-point rise to 0.75 per cent. Furthermore, prices are clearly rising, with the annual rate of inflation hitting a 30-year high of 5.5 per cent in January with expectations of it reaching 7.5 per cent in April.

This has prompted bets that the MPC would order a half-point rise – the first since 1995 before it was given operational independence – as soon as March. But such sharp rises are not only less likely than markets think but would also be a mistake.

The Bank raised interest rates not to tackle a surge in demand, but to deal with the prospect of problems on the supply side of the economy, such as Covid-19 taking people out of the workforce, global goods price inflation, and the impacts of Brexit. The idea that the Bank was sending a signal to pay negotiators that large rises would lead to further rate rises, was made explicit the following day when the governor of the Bank of England, Andrew Bailey, called for pay “restraint”.

But households respond to what is going on in the economy rather than messages from their central bank. The cuts to their disposable incomes forced on them by higher energy and other prices will lead them to cut discretionary spending, which will in turn reduce both growth and inflation.

Indeed, the Bank used its Monetary Policy Report to show inflation dropping to 1.6 per cent based on market interest rate expectations – and not much above its 2 per cent target when assuming that interest rates remain unchanged at their current 0.5 per cent level. And, if rates did rise sharply then the Bank forecasts unemployment rising to 5 per cent rather than staying at close to 4 per cent under current monetary policy. This is why the sort of heavy rates that markets are expecting would be a mistake as it could trigger a fresh downturn just as the economy is trying to rebuild from the coronavirus era. And now the Russia-Ukraine conflict threatens to both fuel inflation and depress growth.

The MPC may have decided to act and sound tough because of a concern that it had failed to forecast the speed at which inflation has accelerated (as did most of the macroeconomic community). It may also have felt the need to send out some clear messaging after some uncertainty at the end of last year.

The markets were left confused by the decision to leave rates on hold in November following apparently hawkish comments from some policymakers including Bailey. It then sprung a second surprise in December with a rate hike in the face of a worsening of the pandemic.

Following the latter course in line with market expectations would raise the risk of a mistake as was seen during the global financial crisis. The rapid global tightening in monetary policy in 2007 and 2008 now appears to have contributed to the impact of that downturn.

Certainly, the European Central Bank’s efforts to combat rising oil prices with rate hikes in the face of economic downturns in 2008 and 2011 now rank as mistakes with the benefit of hindsight.

The Bank of England’s warnings may have done some of the heavy lifting: rises in market lending rates and the value of sterling that may bring inflation down in the medium term.

This latest interest rate decision and accompanying forecasts have smoothed over those communication glitches. Looking ahead, the Bank’s message should be seen as a “yes” to gradual and slow rises in borrowing costs, but a “no” to swift and sudden ones.