Despite the surprising fall in the annual inflation rate to 2.6 percent in June from 2.9 per cent the previous month, economic uncertainty encourages speculation that the Bank of England may raise interest rates in the coming year.
Three members of the Bank’s Monetary Policy Committee (MPC) voted for a rate hike at the 14 June policy meeting. MPC member Ian McCafferty recently called for two rate rises over the next two years, while another member, Andy Haldane, the Bank’s chief economist, said monetary policy should be tightened before the end of 2017.
On 28 June, the governor of the Bank of England, Mark Carney, also suggested interest rates could rise if business investment grows.
Against this backdrop, the key questions are whether economic conditions warrant a tightening of monetary policy and the likely impact a rise in interest rates would have on the fixed income market.
Mr Carney has highlighted the transitory nature of inflation on numerous occasions. The sharp rise in inflation over the last year is mainly a result of the depreciation of sterling following the EU referendum and much of the impact has now fed through.
Nevertheless, in its latest Inflation Report, the Bank said the fall in sterling is likely to keep inflation above its 2 per cent target throughout the next three years, and that arguably gives the MPC the basis for a more hawkish stance.
Given the uncertainty surrounding the UK’s economic prospects, it is difficult to argue that interest rates should go up. Weakening consumer spending highlights the dangers of such a move. Perhaps the most worrying aspect of the first quarter GDP data was the slowdown in consumer spending to 0.3 per cent, which is the weakest growth for more than two years.
The savings rate has recently fallen to a record low, and car sales fell in June for the third month in a row, providing more evidence of the pressures facing the consumer.
The latest construction, manufacturing and service sector purchasing managers indices (PMIs) have all moved lower, signalling that prospects for the UK economy are weakening. The outlook for the economy is likely to remain unclear until further Brexit negotiations in two years time. Even then, there may be a transitional period that would cloud the UK’s economic outlook even longer.
The mixed messages from rate setters at the Bank reflect this lack of clarity. Ben Broadbent, the Bank’s Deputy Governor, said on 12 July that he is “not ready to raise interest rates” due to there being too many “imponderables” in the economy.
Key points
Economic uncertainty encourages speculation that the Bank of England may raise interest rates in the coming year.
The savings rate has recently fallen to a record low.
A rate hike would be unlikely to have a major impact on the fixed income sector.
The main argument for a rise would be related to financial stability. The Bank could simply decide to reverse the emergency rate cut implemented following the Brexit vote. That could be a means of signalling to the financial markets that the extraordinary monetary polices adopted by the Bank will not be in place indefinitely.
