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2 November 2017

What the Bank of England raising interest rates tells us about Brexit

Is Project Fear dead - or yet to begin?

By Julia Rampen

The economists, academics and officials who make up the Bank of England’s Monetary Policy Committee decided on Thursday 2 November 2017 to raise the Bank Base Rate, in what is the first time since the financial crisis the central bank has pulled interest rates up, rather than pushed them down.

The Bank of England acts independently from the government, but nevertheless politicians will be watching closely, as the Bank Base Rate directly or indirectly affects the cost of borrowing, from government spending to voters’monthly mortgage payments.

But what happens with interest rates is also a sign of the economy – think a sailor tacking in the wind – and we can expect any hike to be seized on by both Remainers and Leavers as proof their predictions were correct.

In fact, the current rate of 0.25 per cent is unusually low, even in the context of the last decade. 

In 2007, the Bank base rate was considerably higher – it was 5.75 per cent that July – while it was as high as 7.25 per cent in October 1998. 

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Like other major central banks, the Bank of England slashed rates in response to the global financial crisis. Cutting the rate to 0.5 per cent in March 2009, it hoped to ease pressure on mortgage borrowers and give the government breathing space to deal with debt. 

The decision to cut the rate even further in August 2016 was made shortly after Brexit, when the central bank wanted to keep the economy stimulated.

So in this context, returning to 0.5 per cent is actually returning to the status quo since the financial crisis. 

For Leavers, this may be proof that Project Fear was overblown and the central bank feels shipshape enough to start rearranging the furniture. After all, the plan for years has been to raise interest rates – speculation dates back as far as 2013, and when current governor Mark Carney arrived, he actually introduced “forward guidance” which was widely interpreted to mean raising the base rate when unemployment fell to 7 per cent (that happened back in 2014, and the base rate stayed low). 

But Remainers will point out that the reason why the central bank raises interest rates in the first place – to control inflation.

The Bank of England has long subscribed to an economic theory called inflation targeting, where the central bank’s job is to focus on keeping inflation at 2 per cent. One of the tools it has at its disposal to control inflation is the Base Rate. 

Since Brexit, the depreciation of sterling has made imports more expensive and driven up prices. In September, inflation was at 2.9 per cent. In its notes accompanying the rate hike, the MPC said that it expected inflation to rise to above 3 per cent in October. 

Crucially, the notes continue:

The decision to leave the European Union is having a noticeable impact on the economic outlook.  The overshoot of inflation throughout the forecast predominantly reflects the effects on import prices of the referendum-related fall in sterling.  Uncertainties associated with Brexit are weighing on domestic activity, which has slowed even as global growth has risen significantly.  And Brexit-related constraints on investment and labour supply appear to be reinforcing the marked slowdown that has been increasingly evident in recent years in the rate at which the economy can grow without generating inflationary pressures.

In other words, the forecast for Brexit is inflation, and slow growth. This is the Bank of England responding to the pressures of leaving the European Union, not a sign that the economy is strong enough to easily withstand interest rate hikes. 

The decision of the central bank to raise the Base Rate indicates it is more worried about consumers being able to afford the cost of basic goods than those paying their mortgage bills. Since inflation hits the poorest the hardest, this may suggest the stormiest waters stil lie ahead.