Is the Bank of England’s rate rise too little too late?

Critics have accused the Bank of England of failing to juggle a faltering economy with 40-year-high inflation after its decision to raise interest rates to 1.25 per cent.

The fifth rate rise in as many months came after three of the Monetary Policy Committee’s nine members voted for a more aggressive 0.5 point rise. 

There had been speculation the hawks would prevail after the Fed’s decision to increase rates by 0.75 points yesterday, the biggest jump since 1994.

It’s a sign of just how concerned the MPC is about growth that it opted for the lower rise while also upping its peak inflation forecast this year to just over 11 per cent.

Inflation versus growth isn’t a straight trade-off. The empirical evidence is pretty clear that high inflation is itself a drag on long-term growth. Andrew Sentance, senior adviser at Cambridge Econometrics, said this is the risk the Bank is running: “[The level of] interest rates is totally out of kilter with inflation. Failing to correct this sooner rather than later risks a major recession. We’ve seen two small monthly GDP falls – which don’t signal a major downturn. But letting inflation run out of control would be much worse.”

By historical standards, the mismatch between interest rates and inflation is considerable. The last time that the Retail Prices Index was at the level it is now – 11 per cent – the Bank’s base rate stood at 13.8 per cent.

The question is how high rates might go. Markets expect interest rates to peak at 3.5 per cent, well up from the 1.6 per cent prediction in February. And in its forward statement today, the Bank left the door open to further hikes in the coming months, saying it “will if necessary act forcefully in response” to “more persistent inflationary pressures.”

But analysts are wondering just how high inflation would need to go for the Bank to “act forcefully” if 11 per cent doesn’t cut it.

Paul Dales, chief UK economist at Capital Economics, is among those who think the Bank is getting the balance wrong: “The Bank of England is putting too much weight on the softening economy and not enough on surging inflation. It did hint it may yet raise rates faster in the coming months. But either way, we think the Bank will have to raise rates to 3 per cent.”

Mervyn King, former Governor of the Bank of England, described the 2000s as the “nice” decade – an acronym for non-inflationary, consistently expanding. In response to the rate rise, Karen Ward at JP Morgan Asset Management contrasted this with our new age of uncertainty: “If one had to choose an acronym for our current economic circumstance it could be ‘vile’ – very-inflationary, limited expansion.”

Today’s decision will be taken as confirmation in many quarters that the Bank has failed to adjust to this harsher climate.