The Bank of England is set to raise interest rates to their highest level since 2008 on Thursday in the wake of official data last month that showed inflation remained stubbornly high.
The expected increase in the cost of borrowing would represent the 12th successive boost by the central bank since it started raising rates in December 2021. It comes in the wake of similar moves by the US Federal Reserve and European Central Bank.
Economists will be looking beyond the decision on rates in the Monetary Policy Committee’s messaging, which was finely balanced on future tightening at the last meeting in March, and its new economic forecasts to try to gauge how much higher interest rates could still rise.
How much is the MPC expected to raise rates by?
Economists and the markets almost universally expect a quarter of a percentage point increase from 4.25 per cent to 4.5 per cent.
The rise was far from a foregone conclusion after the March MPC meeting when the committee said it would continue to monitor for “evidence of more persistent [inflationary] pressures” before raising interest rates again.
But in the past month, official data showed inflation in March was running at 10.1 per cent, well above the BoE’s forecast made in February when it expected an easing to 9.2 per cent. Combined with a pick-up in wage pressures and stronger economic data, economists believe that evidence threshold has been reached.
Bruna Skarica, UK economist at Morgan Stanley, said she thought the inflation figures were a game-changer with “stickiness in core goods [inflation], despite fairly lacklustre retail sales volumes”.
George Buckley, chief UK economist at Nomura, said the chances of the BoE doing anything other than raising rates by 25 basis points were “very low”. He added: “Pricing suggests that markets are thinking the same.”
What will happen to the BoE’s forecasts?
The BoE’s starting point will be the higher than expected inflation rate for March. Officials are still expected to forecast price pressures will ease quickly over the course of 2023 as last year’s sharp rise in energy prices fall out of the annual comparison.
Although the initial rate of inflation in May’s forecast will be worse, lower than anticipated energy prices will bring the MPC’s inflation expectations down even faster than predicted in February. This, in turn, would boost household incomes.
The spot price of natural gas is now 82p a therm, less than half of the 189p market price the BoE used for 2023 in its February forecasts. For late 2024, the current futures price is 147p a therm rather than 174p three months ago.
Buckley said the fall in energy prices would allow the BoE to scrap its forecast that the economy would fall into recession this year.
But an improved outlook would also pose a problem for the central bank because it would have to explain why it is raising interest rates when its model’s central forecast is likely to show lower medium-term inflationary pressure.
Officials will justify this approach by pointing to signs of “second-round” effects — economists’ jargon for what most people call a wage-price spiral. But these are not well defined in the BoE’s model, and Jumana Saleheen, chief economist at Vanguard Europe, said some MPC members had “underestimated the transmission of [recent] high inflation rates becoming embedded into the economy”.
Problems with the central bank’s model became evident in February, when officials decided to add 0.8 percentage points to its results to produce what they called a risk-weighted “arithmetic mean” forecast. This approach led to the largest-ever deviation from the MPC’s central forecast.
Economists believe the adjustment factor this time round could be even greater, reflecting concerns among some committee members that high inflation is becoming more ingrained into daily life and pricing decisions by companies.
Will the central bank’s guidance change?
One thing is certain, the MPC will not want to tie its hands and rule out future interest rate increases. Officials are expected to signal that future interest rate moves would be “data dependent” and that there was no bias either way for tightening policy further or reversing course and lowering rates.
MPC members have become increasingly worried about the threat posed by a wage-price spiral. Late last month, the BoE’s chief economist Huw Pill told households and companies they “needed to accept” that they were poorer as a result of higher energy prices. Central bank officials have said they were watching companies’ pricing decisions closely.
Ashley Webb, UK economist at Capital Economics, said the MPC should have communicated the need to make borrowing for companies and households more expensive rather than urging people not to ask for pay rises or seek to defend profit margins.
“Since the bank started to raise interest rates from 0.1 per cent in December 2021 to 4.25 per cent now, it has consistently warned that rates wouldn’t rise very far. If the bank had sounded more hawkish, perhaps price and wage expectations may have declined further,” he said.
Given the uncertainties, the MPC is also likely to talk about the risks that it is running whatever its decision on interest rates.
“The MPC has always taken a risk-based approach, or at least should have done” in an effort “to minimise the probability of large and persistent errors”, said Jagjit Chadha, director of the National Institute of Economic and Social Research.
If the MPC raises interest rates too far before the effects on economic growth and inflation kick in, the risk is that MPC members look like “fools in the shower”, said Silvana Tenreyro, an external committee member, who has consistently voted against rate rises. She warned that further tightening of monetary policy could trigger a sharp downturn.
But the hawks worry that the risk is that the MPC acts too slowly and fails to return inflation to anywhere near the BoE’s 2 per cent target.
For most of the period since interest rates started rising, financial markets have been a better guide than economists or BoE officials in predicting the short-term likely rapid rise in interest rates.
Although the BoE is not expected to signal the need for future rate rises, traders continue to bet on further tightening with the futures market indicating borrowing costs will finish the year at close to 5 per cent.