The Bank of England raised the base rate of interest to 4 per cent today (2 February), the tenth consecutive increase to the cost of borrowing, and the highest bank rate since the autumn of 2008.
The decision was taken by the Bank’s nine-member Monetary Policy Committee (MPC), which is comprised of five senior Bank employees (including the governor and the chief economist) and four external members. But the decisions the MPC takes are also influenced by the decisions of other central banks, including the European Central Bank and especially the US Federal Reserve, which has also been raising rates since the beginning of last year – and yesterday announced its own 0.25 per cent rate rise to a target rate of 4.5 to 4.75 per cent.
Earlier this week, the International Monetary Fund (IMF) presented two quite different directions for the economies of the US and the UK. America’s economy is growing faster than expected, and the IMF forecasts growth of 1.4 per cent in the US for 2023. Britain, meanwhile, is the only major economy that is expected to contract this year (by a projected 0.6 per cent). Why is the same monetary medicine being prescribed for economies that appear to be headed in different directions?
The job of interest rate hikes is to control inflation: the accepted logic is that by making debt more expensive, higher rates limit spending by consumers and businesses, reduce demand and bring prices down. But in the UK, consumer sentiment, which typically rises in January, fell again last month to the third-lowest level since records began in 1974, and business confidence is at its lowest level since the 2008 financial crisis. Our manufacturing sector, as measured by the purchasing managers’ index (PMI), has been in contraction for six months. It is worth asking whether demand in our economy needs much dampening, and whether Britain can afford to follow America’s more hawkish monetary policy.
However, as the MPC member Catherine L Mann (who was actually in favour of a larger rise than the one voted for today) has observed, the UK’s open economy and “substantial cross-border financial flows” mean we are “particularly exposed” to “spillovers” from the monetary policy of other countries.
The reason for this is that our currency is widely traded. Stephen Millard, deputy director of the National Institute for Economic and Social Research, explains that higher interest rates typically mean better returns for investors, which means more demand (and therefore higher prices) for that country’s currency. So if America raises rates by more than the UK, “that might lead to an exchange-rate move in the pound against the dollar. If the Fed tightens by more than the MPC, then you might expect the dollar to appreciate… and movements in the exchange rate will have implications for inflation.” If the dollar is more expensive, goods and services from the US (of which the UK imported more than £100bn last year) become more expensive, adding more upward pressure on prices in the UK.
This relationship is arguably more of a problem for British people than it is for Americans, because of a factor that the IMF identified as a key risk in the UK economy: an overinflated housing market that relies on millions of short-term fixed-rate mortgages. The average American won’t see a change in their mortgage payments, whatever the Fed chair Jay Powell decides to do, but 1.4 million households in the UK will move to significantly higher mortgage payments as a result of the MPC’s decisions this year. The “pass-through” from interest rates is faster in the UK. Fran Boait, executive director at Positive Money, has pointed out that 750,000 households on tracker mortgages, which move up and down with the bank rate, will see their repayments increase by £50 per month as an immediate result of today’s decision.
Millard says it’s not accurate to say that the Bank “has to follow the Fed”, however, because, like other central banks, it has a mandate to control domestic inflation, which is still very high, and doing so involves walking a “tightrope” between allowing inflation to persist and precipitating a recession. “What’s happening in the US is a factor, the exchange rate matters, but so do a whole bunch of other things.”
However, as the minutes from today’s meeting of the MPC show, the Bank is currently working on the expectation (implied by the prices in financial markets) that the Fed will change course, and interest rates in the US will reach a higher peak but come down further from it. Time will tell if this turns out to be a safe assumption – or if the gap between the US and the UK widens still further.
[See also: Inflation]