The Bank of England can’t afford to hike interest rates again

The interest rate hiking cycle has ended - or that’s what it looks like anyway following the latest decisions from the European Central Bank, Bank of England and Federal Reserve. 

In the past week, all of these central banks have announced they’re pausing one of the most aggressive rate hiking cycles in the history of independent central banks. The BoE’s monetary policy committee (MPC) held the base rate at 5.25% at their meeting yesterday, the second meeting they’ve kept rates constant. 

Only the day before, the US Federal Open Market Committee voted to keep rates on hold for the second time, at a 22-year high of 5.25-5.50% (unlike the BoE, the Fed sets a range for its Fed Funds rate). And last week, the ECB held rates at 4%. 

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All three of these leading central banks have hiked rates from zero over the past 18 months, as they’ve tried to bring inflation under control.  

Inflation begins to fall  

So far, the medicine seems to be working. Eurozone inflation dropped to a two-year low in October of 2.9%, from 4.3% a month earlier. Meanwhile, inflation dropped to 3.7% in the US for the 12 months ended September. 

Here in the UK, inflation has proved tougher to control. Since CPI inflation reached 11.1% in October last year it has fallen by more than 4 percentage points, although it flatlined at 6.7% in September. Inflation has remained sticker in the UK due to the energy price cap, which works with a lag. 

Unlike the US and Eurozone, where lower energy prices have already filtered through to consumers and businesses, the price cap is preventing prices from falling as fast here in the UK.

As energy is a big component of the inflation figures, this is something policymakers will be taking into consideration when setting interest rates. 

Higher interest rates are starting to have an impact 

Inflation is just part of the equation for central bankers. While The Fed, BoE and ECB all have a mandate to keep inflation under control, they don’t want to crush their respective economies at the same time. So they have a tough balancing act to practise.

That said, coming off the pedal too early could reverse much of the progress they’ve already made in the fight against inflation. BoE governor Andrew Bailey has said rates must stay, “sufficiently restrictive for sufficiently long”. He’s also recently added, “It’s far too early to be thinking about rate cuts.” 

Across the pond, Fed chairman Jerome Powell has summarised the Fed’s stance as being “not confident we have reached sufficiently restrictive [financial conditions], but not confident we haven’t”.

The markets have a bit of a different view. The market is pricing in interest rate cuts starting in the second half of next year and is only assigning a slim chance to further rate increases from both the BoE and the Fed. 

There are signs on both sides of the pond higher rates are starting to have an impact on economic growth. In the UK in particular, activity in the construction sector has fallen off a cliff and consumers are pulling back on spending as higher interest rates bite. It’s also more appealing than it has been for over a decade to save rather than spend (one of the main reasons why interest rates are so effective at controlling prices). 

Higher interest rates mean it’s more expensive for companies and consumers to borrow money to spend and invest, which reduces demand, forcing businesses to lower their prices. While inflation remains high in the UK, shop price inflation has been falling, suggesting part of this equation is already playing out as businesses compete for customers’ shrinking spending power.  

An upcoming election  

The BoE will have this in mind when it’s thinking about interest rates going forward. If businesses have to fight for consumers' money, business activity in the economy will fall (as is already happening in the construction industry) and that could lead to a recession. Higher interest rates are already forcing the government, which relies of debt to fund the day-to-day running of essential services, to consider benefit and spending freezes. 

With an election coming up, the government may start putting pressure on the BoE to cut rates, or at least hold off on any further rate increases to avoid sending the economy into a recession or driving harsh spending cuts in 2024. 

All in all, there’s a chance the BoE could push rates higher in the coming months if inflation surprises to the upside, but with risks to the economy growing, and inflation falling in the rest of the world, (which will filter through to the UK over time) the central bank may decide to hold off on any further changes or even cut in 2024.