Such was the weight of market expectations that the Bank of England (BoE) would raise rates, that failing to enforce a hike would have caused a minor panic – with investors asking what the Bank’s Monetary Policy Committee (MPC) knows that the rest of us do not.
So it was hardly a shock when they did. As with the last increase, it was the smallest step upwards the Bank could practicably take, and it still leaves rates at historically low levels. A more normal pattern of interest rates, such as obtained before the financial crisis, would be closer to 5 per cent, say, than zero. We’ve become accustomed to very cheap money, which is a dangerous thing in the long run.
Still, businesses and mortgage holders will be squeezed a little more, which is the point – to make it harder for the shops to raise their prices. The Bank senses, rightly, that the current trend of wages growth and strong employment figures could convert into home-brewed inflation across the two-year horizon that policy makers try to peer into.
Even with the economy growing sluggishly, and all the uncertainties surrounding Brexit, those inflationary pressures have been slowly building for a year or two, and the Bank has acted to preempt them turning into a self-fuelling wage-price spiral. What’s more, with the financial crisis having passed some time ago, the banks no longer have such need for easy money to stay liquid, and some of the BoE’s other schemes to support business lending and the property market have been quietly dropped.
We are, then, on the road to normalising interest rates, almost a decade on from the emergency cuts that brought them to 300-year lows. Yet the economy is about to enter a highly abnormal phase – Brexit. With the probability of a hard Brexit increasing, the BoE should now refrain from raising rates until the picture becomes clearer, or as clear as it ever gets with Brexit, after the formal leaving date of 29 March 2019. If the worst predictions come true with a “crash out” of the EU, the BoE may even need to take action to underpin the financial system and the wider economy in the light of unknowable consequences.
A sudden rupture of trading patterns and financial contracts would constitute an external shock every bit as destabilising as the 2008 banking crash, or the oil crises of the more distant past.
There is, after all, a close and recent precedent for hard Brexit, which is the aftermath of the unexpected EU Referendum result in 2016, when sterling crashed and the BoE had to act, successfully as it turned out, by slashing rates to just 0.25 per cent to protect financial stability and the real economy alike.
Whatever may be said about Project Fear, and the BoE’s role in it, the economic effects of that political shock were immediate. A weaker pound therefore seems an inevitable consequence of a hard Brexit (or even a soft one) and will pose a nightmarish dilemma for the BoE, as it will also mean higher “imported” inflation feeding into the system, even as the domestic economy weakens.
The BoE will also be aware that a disorderly exit will affect billions of pounds, dollars and euros worth of financial contracts across Europe, previously predicated on the EU membership, EU law, the EU Court of Justice, and EU freedom of movement of capital.
Europe’s financial “plumbing” runs through the City and Canary Wharf; what will happen if it suddenly becomes blocked? What will happen if euro-denominated deals must be legally cleared, or settled, within the EU, not London? Central banks across the EU and the BoE will need to take evasive action to limit the chaos, including on interest rates. Journalists on Brexiteer newspapers can idly blame Barnier, Merkel and Macron, but that won’t settle a single derivative deal. Someone will need to clean up the mess.
Because the path of the economy in such circumstances is difficult to predict, how weak the pound will be for how long is also hard to judge. If history is any guide, then, as in the 1970s, the deterioration of the external worth of the British currency may be more or less unrelenting.
Central banks do not like to have to lower rates midway through an orderly path to raising them, and having to do so next spring after hard Brexit would be disruptive in every sense. Such a scenario might have been avoided had the BoE not pushed the rates higher now. Either way the case for extreme caution on future rate rises is plain. The BoE, for obvious reasons, prefers not to get embroiled in the Brexit debate, but it simply cannot pretend it isn’t there or is economically neutral. At the moment the BoE seems a little in denial about the very thing they warned so hard about in 2016 – a post-Brexit recession. A U-turn probably awaits governor Mark Carney and his colleagues, say around the time of the MPC announcement in February 2019.