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When will the Bank of England raise interest rates?

06 August 2021
bank of england cloudy bus

Jonathan Marriott, Chief Investment Officer

The annual rate of inflation is above the Bank of England’s 2% target, the vaccination programme is gradually allowing the UK economy to reopen, and unemployment is falling. Against this backdrop, the Monetary Policy Committee met this week and still voted 7-1 to keep interest rates and their bond purchase program unchanged. With inflation expected to rise further, the question is: where next for monetary policy?

At the moment, the Bank of England continues to see inflation as transitory. In their latest report, they expect consumer price inflation to peak at 4% around the end of this year, before falling back to 2% over the next two years. The expected peak is higher than indicated in previous reports, but below what we have already seen in the US, where inflation is running at 5.4%. The recovery from the pandemic has prompted a sharp pickup in demand at a time when supply has been constrained by the pandemic. This applies as much to goods as it does to employment. There are staff shortages in many areas, not helped by the so-called ‘Pingdemic’ of people being told to self-isolate by the NHS app. Many workers from continental Europe returned home during the pandemic and cannot easily return, particularly post-Brexit. However, as factory bottlenecks ease, supply should catch up with demand. In the UK, we still have nearly two million workers on the furlough scheme, not all of whom will be able to return to their old jobs. When this prop is removed, the supply of labour should improve. So, there are plenty of reasons for the Bank of England to see the present rise in inflation as transitory.

However, there is a risk that inflation becomes more entrenched and the Governor, Andrew Bailey, indicated they are ready to respond should this happen. For now, they expect to raise interest rates very slowly and only expect to be at 0.5% by the third quarter of 2024. For bond investors, the fate of bonds purchased by the Bank of England to support the economy during the pandemic will be important. In the latest report, the Bank of England gives guidance on how they expect to manage this position in future. They say they will continue to reinvest coupons and maturities until interest rates are at 0.5% and will only consider selling bonds in the market at least until base rates reach 1%. So, there is little threat in the near-term of them unwinding their positions.

If, on the other hand, the economy slows and inflation drops back below target, they are ready to use negative rates. Some time ago they told banks to be prepared to implement negative rates and this is now in their toolbox for use in the future. For now, this seems a remote possibility, but is a reminder that interest rates, however low, can go down as well as up.

While some businesses and individuals have come through the pandemic well, many others have built up debts. This means that the economy may be more sensitive to rate rises when they come, especially given the strong demand for housing over the past 18 months. We also need to remember that interest rates are not the only way to tighten the economy. The Chancellor is gradually removing the support measures that were put in place to bolster the economy and may look to re-balance the books in future. Thus, some measure of fiscal tightening (higher taxes or austerity) may temper economic growth. If this happens, there may be less scope for interest rate rises in the future.

To conclude, inflation is likely to continue to rise this year, however the Bank of England may not respond by raising rates any time soon. Even when they do so, they (and we) expect this to be a very slow process. They are unlikely to start selling their accumulated bond positions any time soon. As Janet Yellen stated during her stint as the US Federal Reserve Chair, the tightening process should be as dull as watching paint dry.

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