• MPC raises interest rates but forecasts an economic slowdown
• Gilt yields are remarkably sanguine in the face of Quantitative Tightening
• Higher rates could cause a headache for the Chancellor
Laith Khalaf, head of investment Analysis, AJ Bell
“The market was expecting a rate rise, but pulses will be racing now the QE scheme is set to be wound down too, on top of which four members of the Bank’s policy committee wanted to increase rates further to 0.75%. The Bank is clearly now in hawkish mood and is taking soaring inflation seriously. Many will ask what took so long, but as they say, it’s better late than never.
“To be fair to the Bank, the end of the furlough scheme was always a nagging doubt when drawing conclusions about the true state of the economy and now that is out of the way, the scene is set for tighter monetary policy. The Bank has sent a very clear signal that it’s going to level its considerable firepower at inflation. That in itself may be enough to persuade markets, businesses, and consumers that inflation isn’t going to become embedded in the system, which in a circular fashion, is crucial to ensuring that it doesn’t.
“In the short term, the Bank’s decision to raise interest rates won’t alleviate the cost of living crisis, in fact it may worsen it by increasing the cost of borrowing. A saving grace for UK consumers is how many have taken advantage of ultra-low rates by fixing their mortgages, which will defer the pain for many. We’re now looking at interest rates probably rising to 1.5% by the middle of next year, and once the base rate is above 1%, that clears the path for the Bank to accelerate the unwinding of the QE programme. That means selling gilts as well as simply not reinvesting the proceeds of maturing bonds, which itself is equivalent to a £70 billion reduction in QE in the next two years.
“Higher base rate and the unwinding of QE will cause a considerable headache for the Chancellor, because they spell higher borrowing costs. No doubt the OBR will now be applying a fair amount of red ink to its existing debt forecasts for the upcoming spring Budget. Of course, the more the government has to spend on servicing and refreshing its borrowing, the less it has to spend on giveaways which could help ease some of the financial pressures facing UK households.
“Tighter monetary policy will have big implications for the bond market, and yields did rise after the Bank’s latest announcement, even though tighter policy has been gradually priced in over the last couple of months. But at just over 1.3% on the 10 year benchmark, gilt yields are still remarkably sanguine in the face of rampant inflation and higher interest rates. That may be because the Bank has forecast an economic slowdown over the course of the next year, which could limit its propensity to push through rate rises and set a ceiling on how far it’s willing to tighten policy. A less than rosy economic picture over the longer term also explains why the front end of the UK yield curve has risen faster than the back end of late.
“Annual GDP growth is expected to fall from 7.8% now to just 1.8% next year and 1.1% the year after, with unemployment creeping up too. Meanwhile CPI inflation is still expected to be significantly above target at 5.2% this time next year. If that’s not stagflation, it’s pretty darn close. Normally the silver lining to rising interest rates is a robustly growing economy, but the Bank’s forecasts suggest that any boon will unfortunately be short-lived.”
