Could a rise in US interest rates hike the Bank of England base rate?

JPMorgan Chase CEO Jamie Dimon set pulses racing on Tuesday (9 April) when he told shareholders his bank was prepared for US interest rates to rise as high as 8%.

The bank boss said "persistent inflationary pressures" meant the Federal Reserve could hike its rate from the current range of 5.25% - 5.5% to a level not seen in more than 30 years. He also said his bank was prepared for a “very broad range” of interest rates, ranging from 2% to more than 8%. In the UK, the Bank of England’s base rate sits at a 16-year-high of 5.25%.

His comments came ahead of the latest US inflation news. Prior to the release of March’s Consumer Prices Index (CPI), the market had expected the Fed to cut its rate this summer. But a higher than expected annual rate of +3.5% (+3.2% in February) has led to a greater likelihood that rates will stay higher for longer. In the UK, the CPI was 3.4% in February, with March’s figures not due until 17 April.

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There is a link between the Bank of England’s rate and the one set by the Fed given their interplay can affect the value of the pound, and currency alternatives such as gold. So, how worried should we be about potential US interest rate hikes? We’ve asked the experts.

How linked is the Bank of England base rate to US interest rates?

While there is a link between the Fed’s interest rate and the Bank of England’s base rate, James Smith, developed markets economist at ING Economics, says it’s often “overstated”. He says: “[It] was evident between 2016 to 2019 when the Fed hiked rates consistently and the Bank of England did not. Unlike some other central banks which are very clear that they follow what the Fed does, the Bank of England usually plays down this influence.”

However, Smith adds that market expectations for the UK base rate are “often heavily influenced” by what’s going on in the US. It means there is a degree of “feedthrough” that can change financial conditions on this side of the pond. So, while rate rises or rate cuts can take place at different times, the US and UK can often find themselves moving in step with one another over the long-run.

Arguably the biggest link between the two rates comes through the impact of Fed decisions on the value of currency. “Money is a global commodity,” says Laith Khalaf, head of investment analysis at AJ Bell.

“Price changes in a market as influential as the US will spill over into other regions. In particular rising interest rates in the US would lead to a stronger dollar, which would put upward pressure on inflation in the UK, requiring a more hawkish position from the UK’s central bank,” he adds.

Khalaf is echoed by Ruth Gregory, the deputy chief UK economist at Capital Economics. She tells MoneyWeek that this scenario could make the Bank of England twitchy about the “potential inflationary effect of a weaker pound”. But she says it would take a “big fall” in exchange rates to have an “upward effect” on inflation.

Would an 8% US interest rate affect the Bank of England rate?

Gregory also adds that the Bank of England’s decisions are “determined by the domestic economy”. Indeed, the UK central bank’s primary goal is to keep inflation to 2%. But what if the Fed matched Jamie Dimon’s worst-case scenario, and ratcheted its rate up to 8% - what then?

According to ING’s James Smith, the weaker pound in this scenario would be likely to have a material effect on the base rate. He says: “Amid lingering concerns about inflation, the Bank of England would be much less relaxed about this than it was pre-Covid, and in the aftermath of the Brexit referendum. In the unlikely event of materially higher US interest rates, the Bank would be tempted to follow or perhaps more likely, keep rates at current levels for much longer.”

Sanjay Raja, chief UK economist at Deutsche Bank Research, says the outcomes would depend on why the Fed was hiking the US interest rate. “If Fed hikes are driven by domestic factors, the impact would come through via stronger trade and stronger global prices,” he says.

“If the Fed hikes its Fed Funds Rate to 8%, we could start to see more external headwinds build for the UK. UK trade with the US will likely soften as firms spend more cash servicing debts and delivering cost efficiencies than raising demand. The impact will be small but not negligible.”

He adds that any US rate hikes could “arrest easing momentum” for the Bank of England by the end of 2024, and would also restrict its options. If the UK central bank did opt for a rates rise in light of higher rates across the pond, Raja says it could “reignite the risk of a hard landing”.

Another key variable is how healthy the UK economy would be in this scenario compared to the USA’s. Capital Economics’s Ruth Gregory says the UK’s GDP growth is “far weaker” than the US’s. Inflation is also forecast to be “too low” in the UK, while the rate for American consumers is likely to be higher.

This level of divergence means it’s “possible” the Fed could tighten interest rates in a way that’s “not matched” by the UK, she adds.

Echoing Gregory, Deutsche Bank Research’s Raja says this divergence could then pose a question of how far the Bank of England could go without the Fed. He says: “The scale of rate cuts admittedly could be smaller given currency and growth dynamics, especially if commodity prices are lifted on the back of stronger US growth and stronger exports raise growth in such a way that inflationary pressures start to firm in the labour market."

How likely is the Bank of England to raise interest rates?

So, is there a possibility that the Bank of England could find itself increasing interest rates again anytime soon? While none of the experts MoneyWeek spoke to thought such a scenario was likely, they haven’t ruled it out.

Smith says it’s “pretty unlikely” because “uncertainty about the future trajectory” of inflation is lower. He expects the first rate cuts to come at the August meeting of the Monetary Policy Committee (MPC).

Raja agrees, arguing that any hikes are “relatively remote” due to there being “plenty of spare capacity in the economy”, and given forecasts that inflation “will land sustainably around target” in 12 months’ time.

Indeed, one of the few likely scenarios where UK base rate rises could be likely is if the UK economy rebounds in an unexpected way. Gregory says: “The Bank of England would probably need to see an economic resurgence that drives a renewed sustained rise in core CPI inflation and services CPI inflation, coupled with a resurgence in labour demand that reignites wage growth.”

Another would be an “extraneous shock” that would lead to higher inflation, says AJ Bell’s Laith Khalaf, pointing to what we saw more than two years ago when energy prices soared. But he adds that it would take “quite a significant macro shift” for this to lead to a rates increase in the UK.