Laith Khalaf, head of investment analysis, AJ Bell comments on the latest interest rate decision by the Bank of England (Bank Rate increased to 1.25% – Bank of England):
“The Bank of England is playing a game of slowly, slowly catchy inflation, rather than the shock and awe tactics being employed across the Atlantic. Despite the UK starting to tighten monetary policy first, interest rates are now higher in the US. Markets will no doubt seize on this as a sign the Bank of England has bottled it, but an incremental strategy allows the rate setting committee to observe more data as it comes in, and fine tune its approach as circumstances dictate.
“The US economy also has more long-term fixed mortgages than the UK, which makes interest rates across the pond a blunter policy tool, so the Fed has to create a bit of extra bang to have the same effect on a buck.
“No-one should labour under the misapprehension that interest rate rises are going to do anything about eye-watering levels of inflation in the short term. Our inflationary problem is being driven by a supply shock to energy markets stemming from the conflict in Ukraine, and the ensuing sanctions, and no number of interest rate rises will solve that problem. What the Bank is trying to do is head off second order inflationary effects becoming ingrained in the system and taking on a life of their own.
“The Treasury and the Bank of England are effectively playing a the role of good cop, bad cop with UK consumers. On the one hand, the Chancellor is giving away billions of pounds in helicopter money to help ease the cost of living crisis, while at the same time the Bank of England is cranking up the pressure on household finances by increasing borrowing costs.
“Consumers probably won’t be best pleased to find that some of the fiscal giveaways they have been handed by the Chancellor are going to be gobbled up by higher interest rates. But if the Bank had failed to take any action, the pound would have come under further pressure, which adds to the cost of living crisis by pushing up the price of commodities priced in dollars, especially fuel. It would also increase the chance that inflation becomes embedded in the system and lasts for longer.
“The pandemic has hobbled the Bank of England though, because so many people have left the workforce or switched occupation. There are currently 1.3 million job vacancies in the economy, and extremely low levels of unemployment. The result is a clamour for staff in some industries, which has resulted in an 8% jump in private sector wages in the last year. While businesses may have an eye on the increasing cost of servicing their debt, for many their more pressing concern is having enough staff to open the doors and keep the tills ringing. The Bank may find that the huge dislocation in the labour market means that pressing down hard on the brakes has a more limited effect on wage increases than desired.
“Unfortunately, the mechanism by which tighter monetary policy works is very much a stick rather than a carrot, and that means inflicting considerable pain on consumers and businesses, who are already watching their costs escalating at a frightening pace. Higher interest rates should also eventually serve to cool the housing market, as the impact gradually feeds through into mortgage affordability. Base rate is now expected to hit 3% as we enter next year, so we are really only beginning to feel the burn of the Banks’ tightening cycle.
“Hopefully by then we will at least be starting to see inflation cooling, though that is clearly dependent on energy prices not rising further. Ultimately, the risk is that the combination of the energy price shock and rising interest rates leaves the UK in recession, having only just climbed back to pre-pandemic levels of economic activity.”