Quick View: Interpreting The U.K. Rate Hike

By Mitul Patel and Simon Ward

The Bank of England raised its benchmark interest rate by a quarter of a percentage point to 0.5%. The first rate hike for the bank in 10 years is seen as a dovish move by the markets. Our experts share their thoughts on the implications and the markets' expectations of policy direction.

Mitul Patel, Head of Interest Rates

As expected, the Bank of England raised rates by 25 basis points today; the first rate rise in the UK in over a decade. In the accompanying statement, the Monetary Policy Committee (MPC) omitted a sentence that it had included in previous statements which suggested that rates may need to rise by more than the market expects.

The markets interpreted this as suggestive of the MPC being comfortable with them currently pricing in two further hikes over the coming three years. Its inflation forecast suggested that on this expected path of policy rates, inflation would still be above the 2% target in three years' time.

Historically, an inflation overshoot at the three-year horizon would be interpreted hawkishly, and imply a greater degree of tightening would be needed. However, the current substantial risks in both directions suggest that the Bank of England will tread cautiously, and today’s hike is unlikely to be followed up by any further hikes in the next six months unless the economy performs much more strongly than expected.

Many commentators believe that this rate hike is purely in response to temporarily high rates of inflation, induced by prior currency weakness, and as such, is likely to prove a mistake. The Bank of England continues to signal, however, that it is hiking in response to erosion in spare capacity and limited slack in the labor market.

Stagnant productivity and lower population growth rates suggest that the UK may now not be capable of growing much more than 1.5% without exerting upwards pressure on inflation. This suggests that economic data, such as gross domestic product (GDP) growth at 1.5%, which would have been disappointing in the past, may now prove strong enough to lead to further rate hikes.

Should Brexit prove to have a bigger drag on the economy than currently expected, rates are likely to stay on hold for a long period, or potentially be cut back again if the unemployment rate starts rising.

Simon Ward, Chief Economist

The MPC raised the Bank rate from 0.25% to 0.5% as expected, but the accompanying Inflation Report and minutes suggest a divided Committee and no consensus on the next policy move. The Inflation Report forecasts are mildly hawkish, indicating that three further quarter-point hikes will eventually be required to return inflation sustainably to target. However, the 7-2 split vote and a new sentence in the minutes hinting at renewed policy easing if Brexit negotiations go badly have encouraged a dovish market reaction. The view here is that there is modest upside risk to the Inflation Report’s near-term growth and inflation forecasts, and a follow-up rate increase is possible next spring, assuming there is agreement on a Brexit transition.

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