Threadneedle Street chases credibility with rate rise

‘Focusing today on the current backwardlooking inflation rate risks missing the fact that rate rises take two years to have their full effect’

As expected by financial markets, the Bank of England has raised interest rates by a quarter of one per cent to 4.5pc. At the same time, it upgraded its growth forecasts by the largest amount on record, from a recession to stability. This higher growth, combined with concern that inflation is not falling as quickly as food prices continue to rise, prompted the increase in interest rates.

The danger now is that the Bank will find itself overcompensating. Growth in prices is already outstripping growth in incomes by about 4pc a year.

Money supply growth is slowing fast and suggests that we could face deflation in just two years. The Bank’s own forecasts show inflation well below its 2pc target by the end of the same time frame.

Focusing today on the current backward-looking inflation rate risks missing the fact that rate rises take two years to have their full effect.

So why is Threadneedle Street raising rates despite Britain being on course to be the worst-performing of the G7 economies?

It seems to be a desire to get back its credibility. But that will unravel if, as seems likely, it will have to cut rates sharply next year to compensate for over-tightening this year, and inflation drops well below target without significant economic recovery.

This monetary tightening is being compounded by the reversal of quantitative easing.

Based on official announcements, this programme is expected to offload about £80bn a year of securities. Combined with higher interest rates, this has already seen a collapse in UK broad money growth, which is being reflected in high bond yields amidst lower liquidity. In annualised terms, monetary growth in the past few months has been negative.

Just as inflation followed growth in the money supply, it will follow a contraction. Economic growth will also stay in the doldrums, with UK growth next year likely to remain the weakest of the G7 economies.

The one piece of good news is that if the data start to reflect this outcome, the Bank will be forced to rethink its policies. A rapid lowering of rates through 2024 would likely follow.

The other potential benefit would accrue to politicians. This set of circumstances would set the scene for fiscal policy to be more expansive in an attempt to offset monetary over-tightening, even at the cost of a bigger budget deficit.

After all, it will also be an election year.