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Why we expect the Bank of England to raise interest rates

  • Shunil Roy-Chaudhuri
  • 03 December 2021
  • 4 mins

The Bank of England (BoE) surprised many by keeping interest rates on hold, at a record low of 0.1%, on 4th November 2021. However, the rate decision by the BoE’s Monetary Policy Committee (MPC) was in line with our expectations, outlined in our article ‘What impact could the Budget have on inflation and interest rates and how might this affect me?’

In this article, we said three recent government policies could reduce the need for an interest rate rise and this could influence the UK central bank’s decision. These policies were: the increase in the National Insurance rate; the freezing of the limit on lifetime pension allowance; and the increase in tax on company profits. We think these actions could have a dampening effect on UK inflation.

Inflation rates and interest rates are closely linked. For example, when interest rates rise, people’s mortgage payments often go up. This leaves them with less money to spend, which can reduce demand for goods and, in turn, can help bring down the rate of inflation.

High inflation

A key role of the MPC is to control inflation through setting interest rates at an appropriate level and the government expectation is the annual inflation rate should be no more than 2%. However, the Consumer Prices Index (CPI), the commonly used measure of inflation, hit 3.1% in September, leading to widespread surprise that the BoE kept interest rates unchanged.

Significantly, however, the UK central bank had brought down its expectations of economic growth for the third and fourth quarters of 2021. It was nervous about how an interest rate rise might halt a possible economic uplift as we emerge from the pandemic. The BoE also said ‘near-term uncertainties remain, especially around the outlook for the labour market’. (1) Faced with these potential challenges, the MPC kept rates on hold.

Fall in unemployment

Reassuringly, labour market figures published in mid-November were favourable. They show a fall in unemployment, a large rise in hires and a significant increase in average hours worked. (2) This suggests the ending on 30 September of the government-backed furlough scheme, introduced to support the UK economy through the pandemic, may have had a smaller impact than many had anticipated.

There was also a record rise in people moving from job to job, and this was driven by resignations rather than redundancies. Higher salary offers often drive employees to move from one firm to another, so we could see higher pay growth in the coming months. Crucially, rising wages could drive rising consumer price inflation as companies try to pass increased staff costs on to customers. As if to highlight the inflationary pressures, CPI rose to a higher-than-expected rate of 4.2% in October.

Even so, BoE governor Andrew Bailey said in a Sunday Times interview on 21 November that the central bank’s monetary policy could do little to stop some key drivers of consumer price inflation. ‘It doesn’t get more gas, more computer chips, more lorry drivers,’ he said, referring to current shortages. He also described today’s complex economic conditions as ‘two-sided’. (3)

Forecast rises in interest rates

We need to wait for further employment data, due in mid-December and January, before drawing firm conclusions on the jobs market and the outlook for the UK economy. Moreover, we need time to assess the impact of the Omicron variant. However, given the better than expected employment backdrop and the high inflation rate, we expect the BoE to raise interest rates to 0.25% in mid-December and to make modest interest rate rises next year.

Prior to the release of the October inflation figure, the BoE said it expected CPI to peak at around 5% in April 2022. The BoE does, though, expect inflationary pressures to reduce over time, ‘as supply disruption eases … and energy prices stop rising’. Consequently, the central bank expects inflation to ‘fall back materially’ from the second half of next year. (1)

Additionally, the BoE has the working assumption that wholesale energy prices move in line with market expectations for the first six months of its forecast period but subsequently stay flat. However, BoE deputy governor Ben Broadbent said market expectations are for energy prices to actually drop after six months, rather than remain flat. This suggests its inflation forecasts beyond this six month period could be too high.

Against this backdrop, we believe the MPC will, after the expected rate hikes, keep interest rates on hold until 2023.

(1) Bank of England, Monetary Policy Report November 2021.

(2) Office for National Statistics, Labour market overview, UK: November 2021.

(3) Financial Times, 21 November 2021.

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