The Bank of England has lifted the base rate to 1.25%, up 25 basis points, as it now predicts inflation will reach 11% in October. Will it succeed at curbing inflation without throttling the economy? 

 

The increase is the fifth rate rise in six months but still falls short of coming anywhere near the levels seen before the financial crisis as the Bank is taking a slow approach, while inflation has already reached a 40-year high. 

 

Three of the nine Monetary Policy Committee members voted for a steeper rise by 50 basis points. 

 

“We’re seeing the fastest cumulative rate rise since the end of 1988 - and it’s not over yet,” said Sarah Coles, senior personal finance analyst at investment platform Hargreaves Lansdown, pointing out that the market is now pricing in a rise to 2.9% at the end of the year and to 3.3% in 2023 - and that an expected 40% increase in the energy price cap this October will drive inflation higher. 

 

Weak economy creates a double bind 

 

However, weak GPD figures – April saw a 0.32% contraction– shows the economy is shrinking faster than expected, making the Bank of England’s job even harder. “It means we’re set to enter stagflation," said Coles.  

   

 

Senior investment and markets analyst at HL, Susannah Streeter, said the pound has fallen back further against the dollar to $1.20 amid a bleak assessment of the prospects for the UK, while the FTSE 100 and FTSE 250 have sunk by more than 2% and businesses are increasingly concerned according to the Office for National Statistics. 

 

Consumers might be less confident than they have been until now. “After the big Jubilee blow-out it seems shoppers are reining in their spending especially for big ticket items which aren’t essential,” said Streeter. The UK credit and debit card purchases indicator decreased by 6 percentage points in the week to 9 June 2022.  

 

 

The UK’s outlook means the Bank is tightening less aggressively than the US Federal Reserve, which recently increased the funds rate by 75 basis points, to stand at 1.5-1.75%.  

  

“The Bank of England is playing a game of slowly, slowly catchy inflation, rather than the shock and awe tactics being employed across the Atlantic,” said Laith Khalaf, head of investment analysis at investment platform AJ Bell. 

 

An incremental strategy allows the rate setting committee to observe more data as it comes in and finetune its approach, he argued, noting that the US economy has more long-term fixed mortgages than the UK, "so the Fed has to create a bit of extra bang to have the same effect on a buck”. In reverse, however, this also means that UK mortgage holders are more vulnerable to rising rates. 

 

Interest rate rises will however not do anything about high inflation in the short term, Khalaf said. This is driven by the Ukraine war and the associated sanctions on Russia, but, he said, “if the Bank had failed to take any action, the pound would have come under further pressure, which adds to the cost of living crisis by pushing up the price of commodities priced in dollars, especially fuel. It would also increase the chance that inflation becomes embedded in the system and lasts for longer.” 

 

 

There is a further dimension to interest rate rises – they mark a change in the belief that central banks will support asset prices by cutting rates. Shweta Singh, a senior economist at fiduciary manager Cardano, said this central bank ‘put’ “is coming off the table”. 

 

Instead, “we are entering a period when central banks will be willing to limit asset appreciation and economic activity with tighter policy settings in order to tame consumer price inflation”, she said.