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3 Reasons Why the BOE Won't Hike Rates Soon

May 16, 2011 2:13 AM ET
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Forex Gump's Blog
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In its inflation report published earlier this week, the Bank of England (BOE) announced that inflation may hit 5% by the end of the year. By 2013, the BOE sees inflation standing at around 2%, an upward revision from its former estimate of 1.6%.

With those upsized numbers, it's only natural to expect the BOE to raise interest rates soon. But I think I'll go out on a limb and say that even with an upgraded inflation forecast, a rate hike will likely come later rather than sooner. Lemme give you three reasons why I think so!

1. Weak sauce economy

You don't need to be an economic genius to see that the U.K. economy has seen better days. Just last week we caught a glimpse of how cruddy things have gotten for its major industries. The manufacturing, construction, and services sectors all recorded contractions last month, printing red figures in their respective PMI reports.

Actually, concern over economic growth is the main reason the central bank has been holding off on rate hikes, even with stubbornly high inflation staring it in the face. It's not that the central bank isn't worried about rising prices, it's that it's worried MORE about hurting growth.

2. Rate spread

It's easy to look at the BOE's 0.50% official bank rate and say it's too low. I mean, come on, 0.50%?? That's peanuts! But actual borrowing rates in the U.K. are much higher than you think.

The three-month LIBOR, the rate at which banks charge each other for loans, has pretty much been trending up since 2009 and is currently about 1.50% higher than the official bank rate. Since bank funding rates are already pretty high, why raise rates even further?

Mervyn King himself sounded a bit concerned about this when he brought it up in the inflation report. He said he'd like to see the spread between bank funding rates and the official bank rate come down in the next couple of years, probably to make borrowing even more accommodating.

Inflation Magic

3. Inflation persuasion

Some people see the U.K.'s ridiculously high inflation rate and automatically think that a rate hike will make it disappear. This isn't Hogwarts, kids! The U.K.'s problems won't magically vanish.

Truth be told, there's a chance that a rate hike might not even have that big an impact on inflation.

According to King, domestically generated inflation, the portion of inflation that comes from the U.K. itself, is actually "well below target." This means that inflation is being propped up by other factors, such as rising commodities.

Tell me, do you think a rate hike in the U.K. will do anything to temper rising global commodity prices? I didn't think so!

So then when can we expect the BOE to take rates up a notch?

Something tells me that the central bank won't touch interest rates until the fourth quarter of 2011. With the economic outlook as cloudy as ever, I don't see the BOE putting economic growth at risk with an ill-timed rate hike.

Even though the prospect of a rate hike doesn't look to bright in the near future, the pound could still continue seeing gains, especially in times when U.K. inflation falls under the spotlight.

I wouldn't be surprised to see the pound pop up if CPI comes out better than expected on Tuesday. After all, we all know how people love to speculate about rate hikes. But personally, I wouldn't hold my breath for one.


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