The arguments for and against the Bank of England’s rate hike this Thursday are balanced. But ultimately, the members of the central bank’s monetary policy committee should wait and wait. While inflation has risen and is likely to continue to rise in the short term, the longer-term outlook is unclear. A premature withdrawal of support could endanger the still fragile recovery from the pandemic, especially since fiscal policy will also be tightened next year.
Taken alone, the 15 basis point increase expected by investors would only raise the BoE base rate from its lowest ever level of 0.1 percent to its second lowest ever level of 0.25 percent. This will not slow the economy dramatically, nor will it contain inflation. Instead, it would signal to markets, consumers and workers that the central bank is taking the risk of rising inflation seriously. However, the central bank would be unwise to signal with policies that are not in themselves justified; There is no safer way to sacrifice your credibility than playing this game.
Inflation in the UK is just over 3 percent and could climb as high as 5 percent next year. That is well above the central bank’s 2 percent target and alone would be a strong argument for the central bank to reduce its monetary policy incentives. The pandemic programs were launched at an exceptional time and should respond in size and scope to this unprecedented emergency, which is now largely over.
The recovery was much stronger than the BoE initially expected. Employment has quickly recovered from the depths of the pandemic and has returned to levels similar to 2018, when the central bank last hiked interest rates. Instead of the deflationary perspective of the global economy last year, consumers and companies are now expecting further price increases. This increase could be self-fulfilling, devastating to a central bank.
On the other hand, the surge in inflation is partly due to temporary factors and the unusual pace of recovery from the pandemic. Apart from a few popular professions – such as truck drivers – there are hardly any signs of wage increases across the board. National income is still below its pre-coronavirus peak and it’s too early to treat predictions of long-term scarring as set in stone. Further potential outbreaks, as well as the mere possibility of flares, will still put off activity. Fiscal policy will have a dampening effect on growth from next year as a number of tax increases for workers and companies come into effect. That could mean that the BoE has to do more.
While the outlook is uncertain, the BoE needs to take inflation seriously but not rush to hike rates to prove its credibility. Markets will and should make the decision to leave rates as a lag rather than a sustained commitment to loose monetary policy.
Instead, the MPC can highlight that the central bank will soon meet its pre-announced asset purchase target under the quantitative easing program launched at the start of the pandemic. That means they will stop buying government and corporate bonds and even reduce the Bank of England’s support to the UK economy. It can also signal that should it see the need to tighten, it will not fully reinvest maturing bonds, allowing for a smooth and leisurely reduction in its balance sheet over time. Raising interest rates or selling bonds outright carries too high a risk of going too far too quickly.