Daily Management Review

Despite A "Very Challenging" Outlook, Bank Of England Raises Rates For The First Time In History


Despite A "Very Challenging" Outlook, Bank Of England Raises Rates For The First Time In History
The Bank of England increased interest rates on Thursday from 2.25% to 3%, the highest rate increase since 1989, as it issued a warning about the "very challenging" economic outlook.
The central bank predicts that during the current quarter, inflation will reach a 40-year high of approximately 11%, but that Britain has already entered a recession that may last two years, which would be longer than it did during the 2008–2009 financial crisis.
The biggest decision in 33 years, barring a failed attempt to support the pound on Black Wednesday in 1992, was made on Thursday. It was not unanimous, but it was in line with economists' expectations according to a Reuters poll.
Due to the likelihood that the economy was already in a recession, two legislators, Silvana Tenreyro and Swati Dhingra, voted for smaller increases of one-quarter and one-half percentage points, respectively.
However, the majority of the Monetary Policy Committee predicted that rates would need to rise even further, albeit probably not to the 5.2% that financial markets had already priced in when the BoE finalized its forecasts.
"Further increases in Bank Rate may be required for a sustainable return of inflation to target, albeit to a peak lower than priced into financial markets," the BoE said in unusually specific guidance to investors.
Markets predicted that interest rates would peak at about 4.75% just before Thursday's policy announcement.
"The Committee continues to judge that, if the outlook suggests more persistent inflationary pressures, it will respond forcefully, as necessary," the MPC added.
Western central banks are responding to issues that are similar. Due to ongoing labor shortages, supply-chain delays brought on by the COVID pandemic, and, in the case of Europe, a significant increase in energy costs following Russia's invasion of Ukraine in February, inflation has skyrocketed over the past year.
The European Central Bank raised its deposit rate by the same amount to 1.5% last week, while the U.S. Federal Reserve raised its benchmark interest rate by 0.75 percentage points to a range of 3.75-4.0% on Wednesday. Future rate increases may occur in smaller steps, according to the Fed.
Since its last rate increase on September 22, the BoE has experienced weeks of political and financial market unrest. A day after raising rates, the government of former Prime Minister Liz Truss unveiled a $52 billion (45 billion pounds) package of unfunded tax cuts, drawing sharp criticism from investors.
The goal of the policy was to prevent a recession and promote long-term growth, but instead it caused Truss to resign and drove sterling to a record low against the US dollar. It also forced the BoE to support the bond market.
With British government borrowing costs largely returning to their pre-turbulence levels, markets are now more stable. The BoE was able to start selling bonds from its 838 billion pound stockpile of assets for quantitative easing on Tuesday.
The British economy's fundamental issues continue to exist, though. Despite expensive subsidies to contain the increase, consumer price inflation returned to a 40-year high of 10.1% in September and is likely to have increased further last month when regulated energy prices increased.
In the meantime, consumer spending on non-essential items is being severely curtailed by rising inflation.
The BoE predicts that a recession hit the British economy in the third quarter of 2022 and that it will last until the middle of 2024, shrinking the economy by 2.9%. By late 2025, unemployment would have increased steadily to 6.4%, from its current low of 3.5%, the mid-1970s.
The recession would be shorter if the BoE does not raise rates any further, with a quarter of positive growth in the middle and a cumulative output loss of about 1.7%.
However, if the BoE raises rates as much as markets had anticipated, inflation would decline somewhat more slowly, remaining just above 2% in two years as opposed to significantly below.
The BoE's decision-making is particularly challenging because future government policy is unclear.
While most of Truss's tax cuts have been reversed, new Prime Minister Rishi Sunak has indicated there will need to be a squeeze on public spending and potentially higher taxes, the scale of which will not be clear until a fiscal statement on Nov. 17.
Energy subsidies are scheduled to end in their current form in April, but the BoE forecasted that they would continue at a level that is roughly half of what they are now, preventing a sharp increase in inflation in 2019.