Bank of England was behind the curve on interest rates

Higher-for-longer interest rates raise recession risks in developed economies

The BoE has been consistently dovish in its commentary and its forward guidance to financial markets, unlike the Federal Reserve and the European Central Bank. AP

Last week, the Bank of England surprised markets with a 50 basis point rate hike, taking the bank rate to 5 per cent, rather than the 25bp that had been expected, the highest policy rate since September 2008.

Despite being the first major central bank to start raising interest rates in December 2021, the BoE has been consistently dovish in its commentary and its forward guidance to financial markets, unlike the Federal Reserve and the European Central Bank.

As recently as May, the BoE's own forecasts showed inflation would fall “quickly” to around 5 per cent by the end of this year, and reach the 2 per cent target by the fourth quarter of 2024.

Instead, headline inflation came in higher than expected at 8.7 per cent year on year in May, well above headline inflation in the US and the eurozone.

Core inflation, which excludes volatile food and energy prices to provide a measure of underlying inflationary pressures, has accelerated from 5.8 per cent year on year in January to 7.1 per cent year on year in May.

In its statement after the June meeting, the Monetary Policy Committee recognised that services and core goods inflation had been stronger than expected, and attributed this to resilient demand, a tight labour market and still-strong wage growth.

Indeed, the UK economy appears to have held up relatively well given the tightening in monetary policy so far.

The gross domestic product growth was positive in Q1 and also in April, and consumer spending has strengthened slightly. Wage growth averaged 7.6 per cent year on year in the three months to April, likely supporting household spending.

The MPC also noted that the impact of rate hikes to date may take longer to feed through to consumers as there is a higher share of fixed-rate mortgages than in past hiking cycles.

While the 50bp increase last week was a surprise, markets are pricing in another 100bp in rate increases before the end of the year, which would take the policy rate to 6 per cent, and possibly another 25bp increase in Q1 2024.

The MPC statement indicated that if inflationary pressures continue to be persistent then “further tightening in monetary policy would be required”, and in a letter to the Chancellor after the meeting, Governor Bailey said that the MPC would do “what is necessary to return inflation to the 2 per cent target”.

Despite the more hawkish tone from the Governor, Emirates NBD expects only two more 25bp hikes at this stage, although the bank rate is expected to stay at 5.5 per cent until Q3 2024.

Inflation is proving harder to wring out of economies around the world, and interest rates are likely to stay higher for longer in most developed economies.

Central banks in Australia and Canada surprised markets in June by raising rates again after a break. The Fed is expected to deliver at least one more 25bp rate hike in July, and the ECB has also indicated it is not done with raising rates yet either.

The Swiss National Bank increased its policy rate by 25bp last week and indicated that more tightening would be necessary to bring inflation below 2 per cent, while Sweden’s Riksbank is expected to raise rates again this week.

Higher policy rates for an extended period of time may be necessary to bring inflation back down to target levels, but they do raise the risk of deeper and longer contractions in economies which have already gone into recession, and increase the probability of tipping those that are on the brink over the edge.