Bank of England set to spoil party mood with another interest rate hike

Bank of England officials are expected to take their foot off the accelerator when they meet this week to decide how much the cost of borrowing should rise.

The prospect of a year-long recession that would hit living standards, reduce business investment and damage the UK economy’s long-term productive capacity might have made them think twice about any increase, but the bet in financial markets is that a 0.5 percentage point rise on Thursday seems certain.

At the central bank’s Monetary Policy Committee (MPC) meeting last month, interest rates rose 0.75 percentage points to 3%, so this week’s hike will likely be viewed as a more modest twist of the knife for mortgage holders.

Eighteen months ago, borrowers could find a two-year fixed rate mortgage with an interest rate of 1.5%, but now have to accept 5.5% and be glad it didn’t go probably not much higher.

Paul Dales, chief UK economist at consultancy Capital Economics, said the MPC “may signal that it is starting to think more about the level of rates rather than the pace of hikes” when it meets.

“Even so, we think he will want to see more concrete signs that domestic inflationary pressures are easing before halting the hikes,” he adds.

The Consumer Price Index (CPI) stood at 11.1% in October, the highest inflation the UK has faced in 41 years, and inflation is above target 2% from the Bank since May of last year. Most analysts believe we’ve peaked and this week’s numbers will show the November CPI falling slightly, although the rate of increase is likely to remain near double digits until at least spring.

However, prices could fall sharply if service companies, faced with falling demand, find the only way to maintain sales is to lower prices. Business services firms and financial firms have posted windfall profits over the past year and may well afford to squeeze margins.

The MPC is split between a majority who think consumer spending has refused to bend to the Bank’s will and that buyers need a few more rate hikes before the pain starts to bite, and a minority who think that the weight of additional borrowing costs is already having the desired effect.

In the United States, inflation has started to decline in response to price cuts by service companies. The same could happen in the UK and Europe.

Joe Nellis, professor of global economics at the Cranfield School of Management, says that while consumer spending in Britain has held up – thanks to low and falling unemployment, the accumulation of savings during the pandemic and increased reliance on credit – this could quickly reverse in the new year when wage increases are still below inflation. “We are going to experience a sustained decline in living standards over the next two years the likes of which we have not seen in 100 years,” he says. “We are in a precarious situation.

The Office for Budget Responsibility, the Treasury’s independent forecaster, underscored this point when it said recently that inflation-adjusted wages would not return to 2008 levels until 2027.

John Llewellyn, a former senior economist at the Organization for Economic Co-operation and Development, says the UK is in a worse position than the US, where the Biden administration is spending heavily to avoid a recession. The rest of Europe, which faces a severe shortage of gas for domestic and industrial use, is on track for a slight decline.

“While you must be gloomy about Europe as it has been hit hard by deteriorating terms of trade and rising energy prices…there is only one guaranteed place to have a deep recession and that’s the UK,” he says.

In its most recent assessment, the Bank of England said a recession would be long but shallow.

Dales says the base rate could stay above 4% all next year before falling in 2024 as the Bank focuses on getting inflation out of the system. Yet many other economists believe rate cuts could come as early as the spring to prevent a recession from turning into a meltdown.

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