Hands tied: Why the Bank of England feels obliged to raise rates this week
Here we go again. The MPC is on Thursday poised to raise the benchmark interest rate from 0.5% to 0.75%; potentially representing only the second time in ten years that rates will have risen.
Of course I could have written that same paragraph countless times over the last five years. The next step in this tradition of dashed market expectations would be for rates to stay on hold due to a slew of last minute negative economic data and for the MPC to suggest that maybe rates could rise next time.
Yet this time feels different. The economic data could hardly be described as robust, yet Mark Carney and other members of the MPC are making all the right noises and markets are currently pricing in a 90% chance that the benchmark rate will rise to 0.75% on Thursday.
Quick look at the weak economic data
Inflation is declining from its high of 3.1% as the Brexit-related effects of a weak pound have almost fully passed through:
And perhaps most worryingly, core inflation has dipped below 2% and is on a downward trajectory:
GDP growth has also been stagnant. Q1 2018 saw the lowest implied annual growth rate in 6 years, a measly 1.2%:
So why should rates rise? The Bank of England has been wary of acting too soon, and in normal times the MPC would most likely hold off a few months as they did in May. However this time the Bank of England will feel the pressure to act for a number of reasons:
1. Brexit
The August MPC meeting represents one of the last meetings where the Bank of England can begin to normalise rates before the tumultuous six-month period covering the end of the Brexit negotiations begins.
It’s a bit strange to raise rates before a period of almost certain economic volatility, but the bank cannot hold on forever. In order to stabilise prices in the future, the BoE will want some flexibility and it currently does not have that. This brings us onto point 2.
2. Crisis preparations
What does the Bank of England do in a crisis? If rates are already effectively zero then the bank cannot lower them any more (rates could go negative as is the case with some countries but negative rates have shown mixed results). The bank could continue Quantitative Easing, except that the Bank of England’s balance sheet is already bloated and QE is not without side effects.
So rates MUST normalise before the next recession, there is a feeling time is running out. The US has shown rates can rise gradually from the lower bound without significant harm to the economy and is in a significantly better position to deal with any future crises. The BoE will want to converge along this same path as the Fed.
3. Credibility
Thirdly, the BoE must be credible for monetary policy to be effective. Market perceptions of a rate rise are high because the BoE has intentionally communicated that it intends to raise rates. This is arguably more powerful than the interest rate rise itself, as behaviour will have already shifted based on the expectation of a rate rise.
Were the BoE to abandon this rate rise, it may impede the ability of the BoE to successfully communicate its future intentions, which would diminish the impact of monetary policy. I can’t emphasise how important this point is — effective communication is the backbone of successful monetary policy. The BoE would have most likely spoken out if it believed market expectations of a rate rise were out of kilter. As Kallum Pickering, an economist at Berenburg, put it:
“The BoE have let the market get worked up for a hike . . . that’s as good a signal as we’re going to get.”
And so I do believe that despite the weak economic data we will see rates rise on Thursday. This is a good thing. Rates must normalise before any future crises, and with Brexit concerns about to start weighing on business and consumer confidence the BoE may not get another chance.
