by The Bank of England is due to raise interest rates to the highest level since 2008 on Thursday following last month’s official figures that showed inflation remains stubbornly high.
The expected increase in borrowing costs would be the 12th consecutive increase by the central bank since it began raising interest rates in December 2021. This follows similar actions by the US Federal Reserve and the European Central Bank.
Economists will be looking beyond the interest rate decision in the message from the Monetary Policy Committee, which was well-balanced at its last meeting in March for future monetary policy tightening, and the new economic outlook to try to gauge how much higher interest rates could go further.
By how much is the MPC supposed to raise interest rates?
Economists and markets are almost universally expecting an increase of a quarter of a percentage point from 4.25% in 2018. up to 4.5 percent
Growth was far from a foregone conclusion after the March MPC meeting, when the committee said it would continue to monitor “evidence of more persistent [inflationary] pressure” before raising interest rates again.
But last month, official figures showed inflation in March was 10.1%, well above the Bank of England’s February forecast of 9.2%. Coupled with rising wage pressures and stronger economic data, economists believe the evidence threshold has been reached.
Bruna Skarica, a UK economist at Morgan Stanley, said she believes inflation figures have changed the rules of the game because “the stickiness of basic commodities [inflation]despite quite weak retail sales volumes.”
George Buckley, the UK’s chief economist at Nomura, said the chances of the bank doing something different by raising interest rates by 25 basis points were “very low”, adding: “Prices suggest markets are thinking the same.”
What will happen to the BoE forecasts?
The starting point for the BoE will be the higher-than-expected inflation rate for March. Officials are expected to continue to anticipate price pressures to ease quickly over the course of 2023, as last year’s surge in energy prices falls out of the yearly comparison.
Although the initial inflation in the May forecast will be worse, the lower-than-expected energy prices will cause the MPC’s inflation expectations to decline even faster than predicted in February. This, in turn, would increase household income.
The spot price for natural gas is currently 82p per term, which is less than half the market price of 189p the BoE used for 2023 in its February forecasts. At the end of 2024, the current futures price is 147p a term, down from 174p three months ago.
Buckley said the drop in energy prices would allow the BoE to reject its forecast that the economy will slip into recession this year.
But improving the outlook will also be a problem for the central bank as it will have to explain why it is raising interest rates when its model’s central projection is likely to show lower medium-term inflationary pressures.
Officials will justify this approach by pointing to signs of “second-round” effects – economist jargon for what most people call a wage-price spiral. However, they are not well defined in the BoE model, with Jumana Saleheen, chief economist at Vanguard Europe, saying some MPC members “underestimated the transmission [recent] high rates of inflation are embedded in the economy.
Problems with the central bank model became apparent in February when officials decided to add 0.8 percentage points to its scores to arrive at what they called a risk-weighted “arithmetic mean” forecast. This approach led to the biggest ever deviation from the central MPC forecast.
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Economists believe the correction factor could be even larger this time around, reflecting concerns among some committee members that high inflation is increasingly embedded in businesses’ daily lives and pricing decisions.
Will the central bank’s guidelines change?
One thing is certain, the MPC will not want to tie its hands and rule out future interest rate hikes. Officials are expected to signal that future interest rate movements will be “data driven” and that there was no bias either towards further policy tightening or changing course and lowering rates.
MPC members are increasingly concerned about the threat of a wage-price spiral. Late last month, the BoE’s chief economist, Huw Pill, told households and businesses that they “have to accept” that they are poorer as a result of higher energy prices. Central bank officials said they were closely watching firms’ pricing decisions.
Ashley Webb, a British economist at Capital Economics, said the MPC should have communicated the need to raise the cost of borrowing for businesses and households, rather than urging people not to ask for pay rises or try to defend profit margins.
“Since the bank started to raise interest rates from 0.1 percent to in December 2021 to 4.25 percent. now, there is a consistent warning that rates will not rise too high. Had the bank sounded more hawkish, perhaps price and wage expectations could have fallen further,” he said.
Given the uncertainty, the MPC will probably also talk about the risk it takes regardless of its decision on interest rates.
“MPC has always taken a risk-based approach, or at least it should have,” said Jagjit Chadha, director of the National Institute of Economic and Social Research, seeking to “minimize the likelihood of large and persistent errors.”
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If the MPC raises interest rates too far before the effects on economic growth and inflation become apparent, there is a risk that MPC members will look like “fools in the shower,” said Silvana Tenreyro, an outside committee member who has consistently voted against rate hikes. She warned that further tightening of monetary policy could cause a sharp downturn.
But hawks worry there is a risk that the MPC will act too slowly and fail to bring inflation back close to the Bank of England’s 2 percent 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.
While the BoE is not expected to signal the need for future rate hikes, traders continue to bet on further tightening and the futures market indicates that borrowing costs will end the year close to 5%.
