The Bank of England’s (BoE) decision to increase UK interest rates by 25 bp partly unwinds the monetary stimulus it provided last summer, and is unlikely to have a large economic impact, Fitch Ratings says. The BoE looks set to tighten policy slowly, but the first UK rate hike in over decade highlights how shrinking output gaps and tighter labour markets are pushing central banks towards interest rate normalisation.
The BoE said Thursday that its Monetary Policy Committee (MPC) voted by 7:2 to increase the Bank Rate to 0.5%, reversing the cut it made last August in the aftermath of the Brexit referendum. It left the stock of bonds purchased under its quantitative easing (QE) scheme unchanged. Prior to last August, the Bank Rate had been unchanged for over seven years. The BoE’s last rate hike was in July 2007.
Fitch has for some time been expecting the post-referendum interest rate cut to be reversed, although in our most recent Global Economic Outlook (September 2017), we expected this to happen in early 2018. The MPC summary said that all members agreed that future increases “would be expected to be at a gradual pace and to a limited extent,” and that monetary policy “continues to provide significant support to jobs and activity.”
We think another increase is unlikely in the next 12 months, given the impact of Brexit uncertainty on the outlook for investment. Today’s decision does not alter our UK growth forecasts , which see a net trade boost partially offsetting slower domestic demand this year, enabling real GDP to rise by 1.5%, before slowing to 1.3% next year. But it remains to be seen how firms and households adjust to a shift in the monetary policy stance after such a long period without a rate rise.
While the BoE has no intention of slowing the economy down, its decision highlights how tighter labour market conditions (UK unemployment is at a 42-year low) and concerns about adverse supply-side impacts from Brexit have reduced tolerance for above-target inflation. Inflation rose to 3% in September partly in response to the weakening of sterling. We forecast inflation to slow next year, averaging 2.5%, but this would still be above the BoE’s 2% target.
As output gaps close, central banks around the world are generally refocusing on policy normalisation. The BoE said it was “ready to respond to changes in the economic outlook as they unfold” to ensure a sustainable return to target, while supporting the UK economy through its Brexit adjustment. Meanwhile the ECB has announced smaller monthly QE purchases from January, while this week’s Fed statement emphasised solid growth and did little to suggest that it felt that recent low US inflation readings were becoming more persistent.
