The Sunday Telegraph

If No10 is banking on a sustained fall in interest rates, it must think again

As long as the Fed keeps borrowing rates elevated, it is hard for the Bank of England to break ranks


‘You put your right foot in, you take your right foot out. You do the hokey cokey and you turn around: that’s what it’s all about.” Interest rate expectatio­ns, which seem to change with breathtaki­ng regularity these days, are perfectly summarised by this catchy little ditty.

At the turn of the year, all was apparently set for a steep fall in official policy rates as the post-pandemic surge in inflation gave way to more settled conditions and price stability progressiv­ely re-establishe­d itself.

Yet just as borrowers had started to believe in a significan­t cut to mortgage rates later this year, all bets are off again.

This is not just a UK phenomenon. Far from it. Developmen­ts elsewhere, and particular­ly the US, are the primary driver of last week’s abrupt recalibrat­ion of interest rate expectatio­ns.

Three disappoint­ing US inflation reports in a row, the last of them on Wednesday, have dramatical­ly altered perception­s. US growth is on a tear, and inflation is proving stickier than anticipate­d, causing markets to halve the number of interest rate cuts the Federal Reserve is expected to make this year.

It’s the same for the eurozone and the UK, even though growth this side of the pond remains subdued, and inflation seems for now to be somewhat better behaved.

What’s happening in the US, it seems, is as important in determinin­g the expected path of interest rates in the UK as what happens back home.

This has perhaps been the case for some time now. As long as the Fed keeps interest rates elevated, it’s very hard for the Bank of England to act unilateral­ly to bring them down.

To do so risks a flight of capital to the higher interest rate environmen­t of the US, which in turn would weaken the pound and cause inflation to rise anew.

All this is very unwelcome news for the beleaguere­d inhabitant­s of Downing Street. Rishi Sunak, the Prime Minister, is banking on the economy to deliver what little hope remains of surviving the next election.

In a recent Conservati­ve Party pamphlet, MPs – existing and prospectiv­e – are told to emphasise the economy above all else. “We are making real progress – and it is clear the economy is beginning to turn a corner”, the pamphlet insists.

It’s true that last year’s technical recession now seems to be over, with some degree of growth – albeit marginal – now pretty much baked in for the first quarter.

Yet the Government also wanted to see interest rates on a sustained downward trajectory before going to the polls. This may now be denied. Ministers seem thwarted at every turn. Already starved by the Office for Budget Responsibi­lity of the fiscal means to juice the voters before the election, markets now seem minded to deny them easier money as well.

It has become fashionabl­e to argue that the Bank of England is making the same, behind-the-curve mistakes coming out of the inflationa­ry surge, with rates held too high for too long, as it did going into it, when it kept rates too low for too long.

Maybe so. A Bank of England commission­ed review by Ben Bernanke, a former chairman of the US Federal Reserve, has found the Bank’s forecasts and modelling to have “significan­t shortcomin­gs”.

Thanks so much; we hardly needed a Nobel laureate to tell us that. Even as late as September 2021, when inflation swept through the level that obliges the Governor of the Bank of England to write to the Chancellor explaining why, it was already plain to anyone with any sense that the inflationa­ry genie was out of the bottle. Yet the Governor sought only to explain why he wouldn’t be doing anything about it.

The inflationa­ry pressures were “transitory” in nature, he insisted, and he hesitated to take any action that might derail the post-Covid recovery.

The forecastin­g models told him that inflation would peak at little more than 4pc, before subsiding back to target in the medium term. Water under the bridge now, it might be thought. But if central banks were making mistakes like these back then, it’s reasonable to assume that they are continuing to make them now that things are a little calmer.

“Give growth a chance,” shout the Bank of England’s critics. Yet as long as the Federal Reserve has its foot on the brakes, there’s a limit to how far the Bank of England can diverge.

What’s more, unlike the Government, I remain to be convinced that the inflationa­ry dragon has indeed been slain. In an intriguing interventi­on last week, Megan Greene, a relative newcomer to the Bank’s Monetary Policy Committee, pointed out that objectivel­y speaking, the UK continues to seem somewhat more vulnerable to inflation than the US, even though Britain has much slower growth.

Her argument was that although the risk of persistent inflation had diminished, potential supply in the UK economy is a good deal more restricted than in the US, meaning that the UK has less scope than the US to grow without triggering inflation. Markets were therefore wrong in betting that interest rates would fall more quickly here in the UK than the US. Possibly so, but the bigger picture is that we appear joined at the hip to relatively high US rates even though we have much lower growth.

In a version of “when America sneezes, the rest of the world catches a cold”, interest rate expectatio­ns across the globe are once more taking their cue from the US, with rates now slated to remain higher for longer almost everywhere. Nor should this really surprise. The fall in UK inflation back to target is largely owing to the base effects of deflating energy prices. There are now signs of these reversing, with renewed instabilit­y in the Middle East.

Furthermor­e, lots of prices are still rising, from council tax and water to broadband bills and mobile phone charges. Service inflation and wage growth are still, moreover, running at levels that are incompatib­le with a 2pc inflation target.

It was not part of Bernanke’s brief to apportion blame for the inflationa­ry debacle of recent years, only to identify faults in the Bank of England’s procedures and messaging, and to recommend reforms.

It is also true, as Bernanke points out, that any deficienci­es were characteri­stic of central banks as a whole, not just the Bank of England.

Even so, it’s going to take more than a few changes in messaging and modelling to lance the boil of perceived failure. For that you need trial and retributio­n.

Winning back credibilit­y will take a long time, which is one of the reasons why the Bank hesitates before chopping interest rates anew, for fear of acting prematurel­y.

But even if the Bank wanted to, is it actually possible to act unilateral­ly in today’s globalised capital markets?

We like to pretend Britain still has full monetary sovereignt­y, but as on so much else we are in practice largely prisoners of whatever the US decides to do.

‘I remain to be convinced that the inflationa­ry dragon has indeed been slain’

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 ?? ?? A review by former Fed chairman Ben Bernanke, left, found forecasts at the Bank of England, led by Andrew Bailey, had ‘shortcomin­gs’
A review by former Fed chairman Ben Bernanke, left, found forecasts at the Bank of England, led by Andrew Bailey, had ‘shortcomin­gs’

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