Interactive Investor

UK interest rates increased to 13-year high

5th May 2022 13:12

Graeme Evans from interactive investor

As interest rates rise for the fourth time in a row, the Bank of England continues to walk a "very tight line” between tackling inflation and recession.

Inflation at 10% and mounting recession fears today highlighted the tightrope facing the Bank of England after policymakers raised interest rates for a fourth time in a row.

Today’s increase of 0.25% means the Bank’s base rate is at 1% for the first time since the global financial crisis amid the fastest tightening of UK monetary policy in 25 years.

Faced with the prospect that inflation will now top 10% in the final quarter of the year, the Bank came closer than many had expected to taking a more drastic line as three of its policymakers voted in favour of a larger 0.5% rise.

But with the Bank now forecasting that GDP will contract by 0.25% in 2023, compared with a previous estimate of 1.25% growth, the remaining six members of its monetary policy committee preferred a cautious approach.

The stagflation message underlying today’s updated forecasts from the Bank put fresh pressure on the pound, which declined 1.5% against the US dollar to $1.24.

The Federal Reserve, meanwhile, delivered its expected 0.5% increase in rates, but the main focus was on chairman Jerome Powell’s guidance for the approach at future meetings as he reassured Wall Street that increases of 0.75% would not be considered.

Traders had been pricing in around a 35% chance of a 0.75% rise by the Fed in June, with more than 2% of hikes being seen overall over the four meetings from last night.

Powell’s comments triggered a relief rally for markets as the Nasdaq closed 3% higher and London stocks benefited, with Scottish Mortgage Investment Trust (LSE:SMT) among those stronger.

The FTSE 100 index stood more than 1% higher prior to the Bank of England announcement, which is where it remained after the latest increase in rates to the highest level since 2009.

When the Bank raised interest rates at its March meeting to 0.75%, it struck a relaxed tone in its guidance by saying only that a “further modest tightening of policy might be appropriate“.

However, that was before the inflation figure for March of 7% came in five percentage points ahead of the Bank’s 2% target and higher than its 5.9% projection in February.

Inflation is now poised to hit 9% in the current quarter and then go beyond 10% to reflect a further big rise in the energy price cap on top of the 54% increase seen last month. The fall in the pound from $1.30 in mid-April to $1.24 means that currency effects have the potential to become another unhelpful source of inflation.

The problem for policymakers is that the medicine of higher interest rates takes a while to be felt and will probably do little to moderate inflation in the near term. Their ultimate aim is to prevent inflation from remaining above the 2% target over the medium term.

In the meantime, the Bank needs to be careful that its actions don’t cause a major economic downturn. Governor Andrew Bailey summed up the pressures in Washington last month when he said the Bank was “walking a very tight line” between tackling inflation and recession.

Overall, four-quarter GDP growth is expected to be broadly flat in 2023, but today’s minutes said much will depend on how well households manage the cost of living squeeze and the extent they are willing to draw on savings.

Capital Economics recently predicted rates of 3% next year but Investec expects the Bank to pause on higher borrowing costs until 2023 once it has raised rates to 1.25% in August.

Its chief economist Philip Shaw warned recently: “Should the downside risks to the economy be realised, there is a chance that the monetary policy committee will have to reverse at least some of the tightening.”

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