The Bank of England takes out some inflation insurance

With inflation forecast to hit around 5 per cent next year, the Monetary Policy Committee had little choice but to act, though it need not be the start of a long hiking cycle.

The Bank of England’s decision to raise interest rates by a quarter point, to 4 per cent, is an insurance hike to get ahead of the upside risks to inflation and preserve some credibility. Indeed, if the Monetary Policy Committee (MPC) had not acted now, many would have asked when they would ever do so.

Nonetheless, the 8-1 vote was surprisingly hawkish, with the sole dissenter (Catherine Mann) preferring a larger increase, to 4.25 per cent.

This hawkishness can largely be explained by the Bank staff’s new economic forecasts, which surely made a rate increase inevitable. In particular, CPI inflation is now expected to rise to around 5 per cent by the middle of next year.

This may be too pessimistic, depending especially on what happens to energy prices. But there is no doubt that the risks relative to the MPC’s 2 per cent inflation target are firmly skewed to the upside.

MPC members rightly emphasised the importance of “risk management” and “credibility”. It is better to send a clear signal by getting ahead of the inflation risks now, rather than having to respond with even bigger rate increases later.

Inflation has been above the 2 per cent target for most of the last five years, and an increase to at least 4 per cent is baked in for early in the new year. The argument that policymakers should look past “temporary shocks” is surely worn out by now.

Nobody (least of all the Bank) is suggesting that higher UK interest rates will have any impact on global commodity prices. But they could help to prevent an energy-led jump in headline inflation from becoming embedded in the economy, especially when underlying cost and price pressures are strong too.

Photo by Etienne Martin on Unsplash

Economic activity has also been more resilient than expected, and the labour market appears to be stabilising. One or two rate rises are therefore unlikely to trigger a recession, especially as mortgage rates and the cost of government borrowing are already pricing in bigger increases.

This week’s rate hike is also not necessarily the start of a prolonged hiking cycle. With a bit of luck, the Bank of England will not have to raise interest rates much further. And with a lot of luck, especially on energy prices, this week’s hike could still be a case of “one and done”.

In the meantime, there is still little evidence that higher energy prices are having large second-round effects either on inflation expectations or on wage pressures. Money growth also remains subdued.

But while these are good arguments for why interest rates should not have to rise as far as some fear, they were not good enough to keep them on hold this week. Inflation expectations in particular were already too high for comfort, and cannot be allowed to take off.

Borrowers are still having to pay the price for years of government policy failures which have added to costs, including labour and housing as well as energy, and held back productivity. In turn, this has limited the ability of the economy to grow more quickly without generating additional inflation.