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Category: Economics

Interest rate rises to 0.5% to counter inflation “overshoot” following Brexit vote

The Bank of England’s Monetary Policy Committee has voted 7-2, to increase interest rates by 0.25% to 0.5% to counter an inflation “overshoot”....

2 November 2017

Alex Matchett

The Bank of England’s Monetary Policy Committee has voted 7-2, to increase interest rates by 0.25% to 0.5% to counter an inflation “overshoot”. The MPC’s report described the increase as a measure to counter the rise of inflation to what it expects will be a peak above 3% in October 2017. This is 1% above the stated 2% target.

Today’s report, published following yesterday’s vote, attributes the current rise in inflation to the depreciating pound and rising energy prices. However, the report went on to describe a longer term outlook significantly impacted by the UK’s vote to leave the EU last year and its effect on currency, investment and markets. “The overshoot of inflation throughout the forecast predominantly reflects the effects on import prices of the referendum-related fall in sterling. Uncertainties associated with Brexit are weighing on domestic activity, which has slowed even as global growth has risen significantly.” Comparative analysis shows the drop in the pound since the Brexit vote, among other factors, has exposed the UK to inflation at double the current Eurozone rate and 1.4% above what is being experienced in the US.

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The report went on to highlight the impact of the Brexit vote on investment and labour supply, “reinforcing a marked slowdown that has been increasingly evident in recent years in the rate at which the economy can grow without generating inflationary pressure”.

While the MPC expected inflation to “approach” the 2% target by the end of the next forecast period, it paired this with another expectation measure noting, “monetary policy cannot prevent either the necessary real adjustment as the United Kingdom moves towards new international trading arrangements, or the weaker real income growth that is likely to accompany that adjustment over the next few years. It can, however, support the economy during the adjustment process.”

The rate rise comes in conjunction with a unanimous decision to keep the current level of quantitative easing by maintaining the current level of UK government bond purchases by central bank reserves at £435 billion. The inflationary implications of this decision will be in parallel to concerns over “erosion of slack” in the UK economy and limited growth and productivity. The report highlights low investment levels following the Brexit vote and under performance of UK based equity, “compared to their more globally orientated peers”. However GDP growth for Q4 of 2017 was up from 1.3% to 1.5%, going out to a prediction of a steady 1.7% over the next three years. Critically, inflation is set to remain above this, hitting 3% in 2017 before dropping slowly to 2.4% next year, 2.2% in 2019 and 2.1% in 2020.

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Addressing the UK’s well-documented low levels of productivity, the report suggests 2017 will see productivity at one quarter of GDP per hour worked, rising to one and a quarter next year. This in comparison with levels of two and one quarter between 1998 and 2007. While, unemployment will remain steady at 4.25%, the lack of further capacity in an economy with sluggish growth, epitomised by continuing low wage growth of 2.5% means further inflationary pressure – especially when combined with the 20% drop in the pound’s value since 2015.

Along with today’s interest rate announcement the Bank has also published data noting the considerable rise in fixed rate mortgages, to around 60% of total, as borrowers continue to enjoy historic lows despite this first rate rise for 10 years. The role debt and credit goes on to play in the economy is clearly pegged to inflation expectations. In analysing those expectations the Bank notes the looped relationship between sentiment and outcome: “Inflation expectations may influence wage and price-setting behaviour. For example, if companies and households become less confident that inflation will return to the MPC’s 2% target, that may lead to changes in wage and price-setting that make inflation persist above target for longer.” Fortunately for the Bank, it reports that those expectations are currently aligned with its own. However, predictions do account for inflation moving out to between  -0.25% to over 4.5% by 2020.

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