Should the Bank of England hold off from raising interest rates?

Shane O'Neill

Shane O'Neill

In recent weeks we have seen the Bank of England acknowledge the possibility of inflation risks persisting for longer than initially expected – its response has been to talk forward rate hikes.

It feels like an instinctual reaction to higher inflation, and markets have accepted the change in stance – the first hike is fully priced in by the end of 2021, with another two hikes in 2022. But are rate hikes the right move in the current setting or should the BoE take that most challenging course of action and do nothing?

Though central bankers have acknowledged that inflation may prove to be less transitory than initially thought, they remain balanced – highlighting the numerous headwinds that persist and how that may push hikes further away.

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Market participants have been quick to ignore headwind warnings, leaving us in a situation where market pricing could pressure the Bank to hike, whether they really want to or not.

Inflation in the UK, and around the world, has increased markedly post lockdown – but as demand-side inflation has subsided, supply-side inflation has maintained and, in many cases, worsened. Inflationary pressures from energy prices and supply chain bottlenecks do not look ready to subside and will most likely be the cause of longer lasting inflation overshoot.

The problem facing the BoE is that rate hikes do little to solve these issues. Not only do they do nothing to remedy the inflationary pressures, there is an argument that the action itself increases inflation expectations.

So long as the person on the street does not think inflation is an issue, they will not demand higher wages and pay more for goods and services, or so the inflation expectations argument goes. But if the Bank is so concerned about inflation that they rapidly increase rates at a speed not seen for more than a decade, then maybe we should be concerned too?

The concerns for the Bank do not stop there – recent growth data have been lacklustre, potentially pointing toward a slowdown in the economy. Employment data has been strong in recent weeks, but we are yet to receive a single post-furlough data point.

Couple with this the rest of the fiscal tightening coming into action – tax hikes and reduction in universal credit, to name two – and one starts to struggle to find prudent reasons to enter a hiking cycle so soon.

UK insolvency numbers also give cause for concern – insolvencies rose 31 per cent in the second quarter from the three preceding months, with many expecting this trend to remain as government support continues to be pulled back. 

Central bank action has defined the global markets since the 2008 crash; they have had control over the yield curve and the constant printing of money has kept economies chugging along.

The ever-present central bank has created an expectation of action among many market participants – 'What’s the point of the Bank if they don’t hike?' they ask. But the setting is different now. As we come out of an unprecedented global lockdown the headwinds are not financial, as they were post-2008, but supply-chain and in some way social. Tightening monetary conditions will not solve these problems.