Interest rate rise: Too little too late or too much too soon? -
interest rate

Interest rate rise: Too little too late or too much too soon?

During the 15th December MPC meeting, it was decided that UK interest rates would increase to 0.25%. This is the first increase since August 2018, when rates hit 0.75% long before the Covid-19 pandemic. The interest rate increase was passed by a majority of 8 to 1. The MPC also unanimously voted on the continuation of bond purchases and the quantitative easing programme. Ironically, the rise in interest rates comes when many in the City were expressing a degree of caution in light of the Omicron Covid variant.

Even though the new variant has attracted headlines worldwide, the impact on inflation and the UK economy seems uppermost in the Bank of England’s mind. Bizarrely, creating yet another problematic situation, already there is talk of a review of interest rates in February, in light of recent restrictions and their impact on the UK economy. Could we see interest rates fall again in the New Year?

Prospects for the UK economy

Unfortunately, the Bank of England finds itself in yet another challenging situation. Looking back to the November Monetary Policy report, UK GDP was expected to show further recovery in the short term. There was also talk of additional upward pressure on inflation, with many economists expecting a November increase in base rates. However, fast forward to this week’s meeting, and the situation has changed again.

Even though the new Covid variant is more transmissible, it is unclear whether it will lead to significant pressure on the NHS. The government is in the midst of a colossal vaccine booster program that they believe will reduce the impact of Omicron on both healthcare services and the economy. The Bank of England also announced a reduction in forecasted GDP growth for the final quarter of 2021. This has been reduced by 0.5% since the November report. Current expectations suggest that UK GDP will be around 1.5% below pre-Covid levels at the end of 2021, a significant recovery but ultimately slower than expected.

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Unemployment in the UK

Despite the threat from the Omicron variant, the UK employment market appears to be strengthening. The latest Labour Force Survey unemployment rate fell to 4.2% during the three months to October, against 4.5% in the three months to August. The expected increase in unemployment due to winding down the furlough scheme has yet to emerge. Indeed, the MPC expects unemployment to fall to around 4% in the final quarter of 2021.

On the subject of economic performance, upward pressure on wages and consumer demand, the Bank of England made a fascinating observation. The impact of successive waves of new variants has a more negligible effect on economic growth and consumer spending. In essence, it would appear that businesses and consumers are “learning to live” with the ongoing threat. However, the emergence of a highly transmissible variant, prompting more severe illness, could change everything.

Inflation in the UK

Whether the Bank of England should have reacted quicker to the growing threat of inflation will be the subject of many case studies in the future. Over the last few MPC meetings, we have seen the Bank of England caught behind the upward inflation curve, with forecasts very quickly becoming out of date. Indeed, in November, the bank suggested that inflation would peak at around 5% in 2022. Shock horror, the inflation rate hit 5.1% in November 2021 and is expected to peak at about 6% in April 2022. This forced the Bank of England to acknowledge there will be continued upward pressure on energy prices.

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In reality, taking into account the new Covid variant and the extremely high rate of inflation, on balance, the Bank of England had no choice but to increase interest rates. Suggestions that an increase could have been delayed into the New Year – to see the impact of the new Covid variant – seemed to be a risk the MPC were not willing to take. While there was significant support for an interest rate rise in recent months, this has cooled somewhat within the City, with many surprised at today’s move. Whether today’s increase will turn out to be something of a knee-jerk reaction to recent criticism remains to be seen, but the Bank of England’s reputation is yet again on the line.

UK interest rates

The increase in interest rates is the first since August 2018, with many economists expecting further increases in 2022. On the one hand, under normal circumstances, the threat of inflation hitting 6% would usually prompt a more aggressive interest rate policy. On the other hand, the emergence of yet another new Covid variant may yet pose a significant risk to economic growth. The most recent indication regarding interest rates suggests an increase to near 1% by the end of 2022. Unfortunately, we have yet to see any update on this previous MPC strategy. It is difficult to say with any degree of certainty what will happen over the next 12 months.

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Whether the MPC was wise to suggest today’s interest rate rise would be reviewed in February is debatable. In theory, this is a legitimate stance bearing in mind developments with the new Covid variant. However, whether it will do anything to enhance the already damaged reputation of the Bank of England/MPC is a different matter.

Investment and money markets look for guidance from the Bank of England and MPC meetings. Unfortunately, this guidance has been misjudged in recent times and, on occasion, appeared reckless. Stuck between a rock and a hard place, who would be a member of the MPC?

Will the MPC’s gamble pay off?

At this time, opinion is divided on whether today’s interest rate increase is too little too late or too much too soon. On the one hand, the high-risk game of inflation poker seems to have backfired, leaving the MPC with no choice but to increase rates. On the other hand, new restrictions will at best create downward pressure on GDP growth, although to what extent is unclear at present. Early indications suggest the Omicron variant is more transmissible but less dangerous to health, suggesting a limited impact on the UK economy.

If this latest move was to backfire spectacularly, there is speculation this could lead to a change in personnel in critical areas of the Bank of England and MPC. Difficult times to say the least!

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