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Ahead of the Bank of England’s 14th consecutive rate rise since 2021 on Thursday, Prime Minister Rishi Sunak claimed “there is light at the end of the tunnel” on Britain’s inflation fight. After justifiable criticism of the bank for falling behind the curve — with the UK’s high inflation making it an outlier in the G7 — a downward trajectory for price growth is now visible. Since the BoE’s hefty 50 basis point rate rise in June, a product of being too complacent earlier in the year, inflation data has cooled. The Monetary Policy Committee plumped for a less aggressive 25 basis point rise at its August meeting, taking rates to 5.25 per cent. Yet it does not seem confident on what it needs to do next.
The mixed signals from the meeting are particularly concerning when the economy is already straining and the margin of error for causing a recession is small. The MPC’s updated view that persistent inflationary pressures may be crystallising indicates the need to keep its policy tight. But guidance that rates would stay “sufficiently restrictive for sufficiently long” — alongside a split vote, with two members voting for a more forceful 50 bps rise — points to uncertainty over how far and how fast the BoE thinks it ought to go.
A 25 bps increase this month was sensible. Broader price pressures are abating. Food price inflation has slowed to its lowest in a year. Producer price inflation, a leading indicator of the prices shoppers face, has fallen rapidly. Prior rate rises are also squeezing demand. Last month, annual house prices fell by the most since 2009 amid higher mortgage rates. Bank lending has eased. But the MPC’s nemesis has been the jobs market, with wages still growing strongly.
The UK’s robust labour market has kept core inflation, which excludes energy and food prices, too high at 6.9 per cent. Some further tightening looks inevitable. But modelling that showed the BoE reaching its 2 per cent inflation target in 2025 under different interest rate paths created some confusion. Some saw the August meeting as “hawkish”, others underscored more “dovish” tones — highlighting the broader problem the central bank has faced in communicating its plans.
Just how the BoE proceeds matters greatly. Home buyers and those set to remortgage already face thousands of pounds more in annual payments, which will increasingly pinch demand. Business activity is falling sharply too. If the BoE is too dovish there is a risk that inflationary persistence feeds into wage resilience. But if it pushes rates too far, for too long, it risks crushing the economy.
Part of the problem is that it is difficult to get a clear handle on just how much previous rate rises are squeezing the economy. Few central banks have got to grips with that. The MPC itself, as governor Andrew Bailey admitted, is not leaning much on its own internal model. The planned review by former Federal Reserve chair Ben Bernanke is very welcome, and will hopefully go some way to improving the BoE’s processes.
For now, the BoE will need to tread carefully and keep a very close eye on the data. It was playing catch-up before, but now the economy is looking more delicate and price pressures are easing. A slow and steady approach from here would be wise to gain a clearer picture of where the economy is.
Britain was the first major advanced economy to raise rates, but the last to leave double-digit inflation. The BoE would surely not want it to be the last to recover from a substantive interest rate-induced recession as well. The light at the end of the tunnel should not lead into a ditch.