The Bank of England’s decision to lift the UK base rate in December 2021 caused many in the market to mutter about the timing.
The central bank had hinted that rates would rise earlier, and sterling had risen in value relative to other currencies in anticipation.
November came and went without a rate rise, and just as the market was beginning to ponder the possibility of monetary policy staying looser for longer, rates rose in December, and then again in February, taking them back to the pre-pandemic level of 0.5 per cent.
Monetary policy is typically framed around two calculations, that of the output gap and the neutral rate of interest, known as r*, both of which will be explained further below.
But a key question for investors is how much faith can one place in those traditional economic measures, given the unusual nature of the pandemic-induced recession and recovery?
It is also worth noting that any perceived change of course by the BoE around lifting interest rates was mirrored by other central banks. As recently as June 2021, a majority of the members of the US Federal Open Markets Committee (FOMC) declared they did not see a need for interest rates to rise before 2024, but have now reverted to the view that rates should rise in 2022.
Recent communications from the European Central Bank also point to a shift in stance towards rates rising sooner rather than later.
Guy Miller, chief market strategist at Zurich, says: “We thought that after years of fighting deflation, having some inflation would be a high-class problem. But having gone higher than expected, it is now a problem nonetheless.
"It is probably right that the UK has moved first to put rates up, due to Brexit. But central banks need to improve their communication skills, [BoE governor] Andrew Bailey has not done a good job in that regard.”
Miller acknowledges that the pandemic has “distorted” economic trends, and that central banks have been content to let economies grow and have inflation above target as economies re-opened after the pandemic and as part of the view that the present inflation is transitory and comes from the supply side.
But Miller cautions that “inflation can be a self-fulfilling prophecy”, as the temporary factors become permanent simply because consumers and businesses react to the temporary inflation in a way that causes it to become permanent, by, for example, asking for higher wages.
Stewart Robertson, chief economist at Aviva Investors, says it is higher wages that is particularly concerning to the BoE right now.
He says that with the economic consequences of the pandemic “receding” into the distance, it is appropriate for central banks to be lifting rates higher than the “emergency” levels at which they were set last year.
Robertson says the US may be raising rates too slowly, while the UK is “about right”, in terms of timing.