London August 1 2022: The Bank of England this week is expected to push through the biggest interest-rate increase in 27 years and unveil its strategy for unwinding some of the £895 billion ($1.1 trillion) of stimulus it delivered over the past decade.
The measures would accelerate a historic tightening of monetary policy to choke off the worst bout of inflation in 40 years. Governor Andrew Bailey and his colleagues have warned that prices may leap 11% this year, well above the 2% target.
The UK central bank also is concerned about falling behind peers, especially the US Federal Reserve, which raised rates a total of 1.5 points at its past two meetings. For the BOE, rate increases also will underpin the value of the pound, which has fallen 10% against the dollar this year.
“The inflation picture has materially worsened, and the messaging from the governor -- 50 basis points is on the table -- suggests to us that they are ready to get forceful,” said Liz Martins, senior economist at HSBC Bank Plc in London.
What Bloomberg Economics Says …
“The BOE signaled at its June meeting that it would ‘act forcefully’ if it saw signs of persistent inflationary pressure. We think the run of data since then will prompt a 50-basis-point hike in August. Our base case is the central bank will then revert to more traditional 25-basis point increments following this meeting, taking rates to 2.75% by February. The risk is that a faster pace of tightening continues into the fall.”
Investors anticipate a 70% chance of a half-point increase in the BOE’s benchmark rate to 1.75%, the highest since the global financial crisis in 2009. While most economists also see a move of that scale this week, some including Morgan Stanley and NatWest Markets say a quarter point is more likely, citing rising recession risks.
A decision is due at noon on Aug. 4.
The move complicates the economic backdrop for the candidates vying to replace Boris Johnson as prime minister. Foreign Secretary Liz Truss and the former Chancellor of the Exchequer Rishi Sunak are seeking to woo members of the ruling Conservative Party with a package of measures to help people cope with surging bills and energy prices.
The BOE’s rate rises are taking money out of people’s pockets by increasing borrowing costs. Figures published by the central bank Friday showed the effective interest rate on new mortgages rose to 2.15% in June, the highest level since late 2016. The rate has jumped by 65 basis points since November.
So far, the BOE has increased rates five times since December, moving in no more than quarter-point steps. The Fed’s actions and a series of above-forecast UK inflation readings prompted British policy makers to rethink their more gradual response and promise to act “forcefully” if necessary.
The last time the BOE raised interest rates by 50 basis points was in February 1995, when the government set the cost of borrowing with advice from the central bank. The meetings between Kenneth Clarke, the then chancellor, and Eddie George, the BOE governor, became known as the “Ken and Eddie show.”
At the time, the fear was that the economy was growing at a rapid and unsustainable pace. GDP was expanding at around 4% a year, inflation had picked up and business surveys showed wholesale prices rising. Clarke had already announced half-point moves in both September and December 1994.
This week’s decision will pivot the BOE further away from more than a decade of easy money to stimulate the economy through the financial crisis and then the coronavirus pandemic. The BOE bought £895 billion of government and corporate bonds during that time to keep a lid on borrowing costs in financial markets.
Bailey has said the decision this week will include details about how the BOE will sell off part of the portfolio. In February, it stopped reinvesting the proceeds of matuiring assets. Now it’s considering active sales, which Bailey said could be in the region of £50 billion to £100 billion in the first year of the program.
Together, the rate increases and asset sales mark a massive shift away from the easy money policy prevailing in the past decade and are designed to raise borrowing costs to more normal levels. Investors are betting the key rate reaches almost 3% by early 2023, while economists are more cautious.
Both see rates having to go higher than would otherwise be the case if Truss becomes prime minister and delivers on her pledge to cut taxes by £30 billion.
It’s also highly unusual for the bank to raise rates while the economy is facing a high risk of a recession. The UK may suffer the slowest growth in the Group of Seven industrial nations next year after rebounding from the pandemic more quickly than most, the International Monetary Fund estimates.
Headwinds for the economy include the worst squeeze on consumer spending power in two decades and Britain’s decision to exit the European Union, which has reduced trade and robbed industries such as construction and hospitality of foreign workers.
Firms across the economy are experiencing chronic labor shortages, despite recent signs that the strains are easing. Almost 400,000 people of working age have dropped out of the workforce since Covid-19 first hit, reflecting an increase in long-term sickness and people taking early retirement.
For those available to work, big pay increases are on offer, though for all but the richest 1% of workers they are not large enough to keep pace with inflation.
While the outlook weakens, the BOE is looking on with alarm at signs that inflation expectations are now well above the 2% target. Business surveys show executives expect strong inflation to persist for years and are planning to raise prices aggressively to protect their profit margins.
“Shortages are leading to output falls,” said Kallum Pickering, an economist at Berenberg. “In value, retail sales are growing very quickly, but in output terms it’s declining. That gap is both the inflation and the difference between what people would like to consume and what they actually can consume.”