UK interest rates: Bank of England shrugs off Brexit nerves to launch first hike in over a decade

The increase in the cost of borrowing will have an immediate impact on millions of households with variable rate mortgages and is expected to dampen economic activity over the coming months

Ben Chu
Thursday 02 November 2017 13:01
History of the interest rate

Interest rates have been hiked by the Bank of England for the first time in more than a decade, even as wages are growing weakly and the country faces the growing threat of a disastrous ‘no deal’ Brexit in March 2019.

The Bank's Governor, Mark Carney, has also strongly signalled that at least a further two rate rises will be needed by 2020, something that will concern millions of Britons with floating-rate mortgages.

The Bank’s nine-person Monetary Policy Committee voted by a margin of 7 to 2 to increase rates from their historic low of 0.25 per cent to 0.5 per cent.

It was the first rate hike from the central bank since July 2007, before the financial crisis and marks an important milestone in monetary policy.

The increase in the cost of borrowing will have an immediate impact on households with variable rate mortgages and is expected to dampen economic activity over the coming months, even as the economy is expected to be buffeted ahead of the UK’s scheduled departure from the EU in March 2019.

The hike had been almost universally expected by financial markets, after the MPC had previously signalled in August that it was likely to increase rates by the end of the year if the economy developed as expected.

The detail of the Bank's latest Inflation Report also supported the view that at least two more rate hikes will be needed by 2020 in order to bring inflation back down to target, quashing the idea of a "one and done" strategy, where the Bank raises rates and then waits for an indefinite period before acting again.

First rate hike in a decade

"We in fact need those two additional rate increases in order to get that return of inflation to target and in fact if you look closely at the forecast, inflation approaches the target, it doesn't quite get there, and the economy is likely to be in a position of excess demand," Mr Carney said at a press conference.

Nevertheless, the pound slumped in the wake of the decision, trading down around 1.3 per cent against the dollar on the day, suggesting traders interpreted the decision in a more "dovish" light, perhaps influenced by the Bank's stress that the quarter point rate rise was "modest" and that future hikes would be "gradual and limited".

The minutes of the MPC meeting cited signs of a pick up in “domestic inflationary pressures” and “persistent weakness in productivity growth” as the main justifications for its rate hike.

Inflation hit a five-year high of 3 per cent in September.

However, the Bank said its forecasts are based on the assumption of a “smooth adjustment” of the UK economy to Brexit, something that has been thrown into increasing doubt by the failure of the Government to make any substantive progress in its Article 50 divorce negotiations with the European Union.

The OECD’s most recent forecasts, by comparison, are based on the assumption that Britain crashes out of the EU in 2019 without a trade deal or the hoped-for two-year transition period and that UK exporters to the EU face the sudden imposition of tariffs and other damaging trade barriers.

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Two MPC members - Sir Dave Ramsden and Sir Jon Cunliffe - voted to keep rates on hold at 0.25 per cent, disputing the majority view of the committee that average wage growth would pick up next year to 3 per cent.

Wages are currently rising at a rate of just 2.2 per cent, below the rates seen in 2015 and 2016 and despite years of projections from the Bank that this would rapidly rise to the pre-financial crisis growth rate of 4 per cent.

Some economists have warned the Bank is in danger of making a policy mistake by raising rates prematurely and that the move may have to reversed if the UK growth rate collapses ahead of Brexit.

After the last rate hike in 2007 the Bank was forced to cut rates again within five months as the global credit crunch intensified.

Given the unusually long duration since the last rate hike the Bank’s move is something of a gamble in terms of estimating the likely response of households to more expensive borrowing.

But the Bank does not expect the latest rate hike to have a dramatic impact on overall household spending, in part because only 40 per cent of mortgages by value are on floating rates, which change automatically with Bank rate.

At the time of the last rate hike in 2007 the floating rate mortgage share was closer to 60 per cent.

Fleshing out its essentially pessimistic view of the UK’s near-term economic prospects, the Bank said its latest estimate of the country’s rate of "potential supply growth" - the rate of growth the economy can handle before running into dangerous inflationary pressure - over the next three years to be only about 1.5 per cent a year, or 0.4 per cent a quarter.

In the third quarter of 2017 UK GDP grew by 0.4 per cent, up from 0.3 per cent growth in the second quarter, but below the 0.6 per cent growth recorded in the eurozone.

It now expects inflation to have peaked at slightly over 3 per cent in October, before gradually descending to 2.15 per cent by the end 2020, slightly above the Bank of England's official target.

"We expect the Bank of England to err on the side of caution in raising interest rates as the UK goes through a potentially substantial economic adjustment related to Brexit," said Don Smith, chief investment officer at the investment management firm Brown Shipley.

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