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After the sharpest tightening in monetary policy for 35 years, UK interest rates may finally be close to a peak.
That was the message on Thursday from Bank of England governor Andrew Bailey, as he set out forecasts for inflation to inch back to the central bank’s target against a backdrop of near-stagnant economic growth.
Starting in December 2021, the BoE has raised its benchmark rate 14 times in swift succession, with the latest quarter point increase taking it to 5.25 per cent. Now, the medicine is finally starting to work.
For the first time, the BoE Monetary Policy Committee has said explicitly the policy stance is “restrictive”, with higher borrowing costs increasingly weighing on the economy and cooling inflation.
Its latest forecasts suggest if interest rates followed recent financial market expectations — rising to 6 per cent in the near term before falling from 2024 — inflation would return to the BoE’s 2 per cent target within two years. Keeping interest rates at 5.25 per cent for a sustained period would produce similar results.
“There is more than one path from here that delivers us back to the target,” Bailey said at a press conference following the MPC rate decision.
Policymakers could still raise interest rates further if they see warning signs in the economic data.
Consumer price inflation fell more than expected in June, to 7.9 per cent. The BoE is reasonably confident headline inflation will continue falling in the near term, as energy and food prices ease, but it remains worried that rapid wage growth will lead to “sticky” services inflation.
“I don’t think it’s time to declare it’s all over and say that we are sticking where we are for the moment . . . We have to remain evidence driven,” said Bailey. “If we get evidence of more persistent inflation then we will have to react to that.”
But economists said any further rate rises by the BoE looked likely to be more a matter of “fine tuning” than a significant change in stance.
“As monetary policy is now ‘restrictive’, the bar for large further rises in bank rate is high — by definition, tight policy is disinflationary,” said Kallum Pickering, economist at Berenberg.
Philip Shaw, economist at Investec, said unless pressures in the labour market turned out to be “considerably more durable than we believe . . . we should be close to the terminal level of bank rate”.
However, the MPC also made it clear interest rates were likely to remain higher for longer than in previous tightening cycles, saying it would “ensure that bank rate was sufficiently restrictive for sufficiently long”.
“We interpret this as meaning that rates are now close to their peak and will then stay at high levels for some time,” said Andrew Goodwin, economist at the consultancy Oxford Economics, who thinks the BoE will start loosening policy “several months later than in the US and eurozone”.
The BoE has come under fire for repeatedly failing to predict the rise and persistence of inflation, which remains far higher in the UK than in many other advanced economies.
Bailey said that while the BoE could learn “important lessons” on how to handle big economic shocks — such as Russia’s full-scale invasion of Ukraine — “I do not think we got monetary policy fundamentally wrong”.
However, a BoE victory in the fight against inflation now looks likely to carry a higher cost to the economy than the central bank anticipated in May, when markets were expecting interest rates to follow a much lower path. Traders revised their view after April’s inflation figure was well above the BoE’s forecast.
The new BoE forecasts show gross domestic product will be barely increasing in 2024 and 2025, with growth remaining below its pre-pandemic rate in the medium term.
Unemployment is also set to rise more than the central bank expected in May, from its current level of 4 per cent to a peak of just below 5 per cent by the autumn of 2026.
Bailey sought to cast these forecasts in a positive light, saying the economy had proved much more resilient than feared at the start of the year, partly because household incomes had held up relatively well, and consumers had felt able to use some of their savings to cushion spending.
“Unemployment is at a historically low level — that’s good,” Bailey said. “Growth is more resilient. We haven’t had a recession and we’re not forecasting one.
“Of course, we would emphasise, monetary policy has had an effect . . . but if we don’t bring inflation down, the effects are worse.”
Ben Broadbent, the BoE’s deputy governor for monetary policy, said one reason for the economy’s resilience was that household incomes were now rising again in real terms, with earnings growing faster than inflation as the price of energy and some key imported goods began to fall.
But analysts said even if the economy escaped a recession, the prospect of near-stagnant growth was still a bleak one.
The BoE forecast for GDP in 2024 and 2025 looked “exceptionally weak”, said Goodwin of Oxford Economics, but this reinforced the idea “that the BoE views virtually any growth as being inflationary”.
James Smith, research director at the Resolution Foundation think-tank, said households were set to pay a high price for “taming inflationary pressures from Britain’s tight labour markets”.
He added: “The likely backdrop to an election next year will be falling GDP, higher unemployment and big increases in mortgage repayments.”
