BoE and UK government pulling in different directions

Millions of households are facing a hefty increase to their mortgage costs today after the Bank of England raised interest rates to the highest level in 14 years, in an effort to tame near double-digit inflation.  

In the seventh consecutive rise since December 2021, interest rates have jumped by another 0.5% to their current level of 2.25%. This means typical mortgage repayments, for those not on fixed deals, have increased by £250 a month. 

Today’s decision did however defy market expectations: many economists had predicted – and hoped – that the Bank would make history today by unleashing its first 0.75 percentage point increase since it gained independence, to tackle inflation quicker.  

The Monetary Policy Committee was divided on the matter: three members did vote for a bumper 0.75% hike, while four, including Governor Andrew Bailey, erred on the side of caution, backing 0.5%. 

The Committee has hinted at a faster pace of tightening in November, once it has had time to properly assess the impact of the new government’s fiscal announcements. 

One factor which will have swayed the decision this time round is Liz Truss’s energy support package. The confirmed price cap on energy bills means the MPC predicts that inflation will now peak at just under 11% in October – lower than its previous forecast of at least 13%. That said, the scale of the Truss’s package will add to inflationary pressures next year, say critics. 

Many in the foreign exchange markets had expected the UK to take heed of the more hawkish approach adopted by the US yesterday. Defying their expectations will do little to help the pound’s poor performance against the dollar. 

Last night, the US Federal Reserve raised its benchmark rate by 0.75 percentage points for the third month in a row. Following the decision, the pound fell below $1.13 for the first time in 37 years.

In the year to date, the pound has fallen by 16 per cent against the dollar, having started the year trading at more than $1.34.

Notably, the European Central Bank has also braved a 75-point rise before its British counterpart. 

In the long term, however, financial markets predict that the UK will actually go higher than both the US and the Eurozone, and raise rates to almost 5%. 

Today’s meeting is the backdrop to the new Chancellor’s big fiscal announcement. 

Tomorrow, Kwasi Kwarteng, will provide details of the government’s energy price guarantee and announce a series of sweeping tax cuts which aim to stimulate growth. Paul Johnson, director of the IFS, says it will be the biggest tax-cutting fiscal event since 1988.

But just how compatible is the government’s approach with that of the Bank? 

Some economists have raised concerns that the two are pulling in different directions. The Bank is trying to squeeze inflation, effectively slowing the economy. Truss and Kwarteng are injecting stimulus in the hope it will avert or limit the slowdown.

To take but one example, 24 hours after the MPC hikes up interest rates to make mortgages more expensive, Kwarteng will announce a stamp duty cut in an effort to stimulate the housing market. 

The Bank is trying to slow down the economy. The new government is borrowing tens of billions in an effort to pump growth and speed it up.

What could possibly go wrong?

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