Although the Bank of England (BoE) defied market expectations for a hike in interest rates earlier this month, policymakers have given a strong indication that, assuming the economy pans out as they expect, tighter monetary policy will be necessary ‘over the coming months’ to return inflation to the 2% target1. Exactly when the Monetary Policy Committee (MPC) will raise Bank Rate from its current level of 0.1% is open to debate, and will in large part depend on how the labour market data pan out following the termination of the furlough scheme at the end of September. However, the extent to which rates rise will ultimately be more important than the precise timing of any move. This month we take a look at what the coming monetary tightening cycle might look like and some possible ramifications.
1. The Bank does not expect interest rates to rise much above 1%, if that
The Bank of England (BoE) sets interest rates with the aim of meeting its 2% inflation target. However, because the current inflation overshoot is mainly seen as ‘transitory’, policymakers do not anticipate steep rate hikes to bring it back down. According to the Bank’s latest forecasts, inflation is seen rising from 3.1% in September to a peak of around 5% in April of next year. Thereafter, inflation drops to just above 2% in two years’ time, as global supply chain disruptions ease and energy prices stop rising. This forecast is conditioned on the market-implied path for Bank Rate (i.e., the market’s expectation for the path of the Bank’s policy rate derived from derivatives markets) which, at the time the projection was made, saw rates rising to 1.0% at the end of 2022 and peaking at 1.1% during the fourth quarter of 20232.
This is all a bit wonkish, but the interesting point is that, during the press conference following the November MPC meeting, BoE Governor Andrew Bailey chose to stress that on this market-implied path of interest rates, inflation would be below 2% and falling by the end of 2024. The key takeaway here is that the Bank’s economic model would appear to suggest that rates will not need to rise as high as 1.1% to bring inflation back to target. Indeed, if wholesale energy prices fall at a faster pace than that assumed in the Bank’s forecasts (which is a distinct possibility), inflation would be markedly lower than the Bank’s central projection during 2023-244. In turn, this might suggest even fewer rate hikes will be required to achieve the 2% inflation target.
2. ‘Real’ rates are likely to remain negative
Following on from this, we can conclude that the BoE anticipates that Bank Rate will remain negative in ‘real’ terms during the coming years. The ‘real’ interest rate, a crude measure of which can be obtained by taking the interest rate and subtracting the current rate of inflation, gives a better idea of the stance of monetary policy because it reflects borrowing costs and returns on savings once the rise in the price level is taken into consideration. Although real interest rates were positive from the early 1980s until the Great Financial Crisis of 2007-08, they have been negative pretty much ever since. This partly reflects elevated levels of debt and a decline in what economists call the equilibrium interest rate (i.e., the policy rate that will keep inflation and growth rates stable when the economy is running at full capacity), which has fallen due to demographic trends and slower productivity growth5 – factors which are unlikely to change anytime soon.
Looking at the Bank’s projection for inflation, and the market-implied path of interest rates, the ‘real’ Bank Rate will actually fall to -4.1% (0.2% minus 4.3%) by the end of 2021 and will still be negative to the tune of 2.4% (1.0% minus 3.4%) by the end of 2022. This suggest real interest rates will remain highly accommodative – borrowing will still be attractive, and saving unattractive – and supportive of economic growth (by way of context, real rates rose above 7% prior to the 1990-91 recession). Against this backdrop, some might question whether more aggressive rate hikes will be needed to bring inflation under control during the coming cycle. There is a great deal of uncertainty in this regard, but it is important to remember that although interest rates will be the primary tool that the Bank will use to tighten monetary policy going forward, it will not be the only one.
3. Tighter monetary policy is not just about interest rate hikes
It will be remembered that the monetary policy response to the economic downturns triggered by the financial crisis and the pandemic did not just entail interest rate cuts, but also quantitative easing (QE, or buying bonds). Conversely, the exit from emergency stimulus will not only involve interest rate hikes but also adjustments in the Bank’s balance sheet.
The Bank of England has already slowed the pace at which it is buying bonds6, and in November three members of the nine-member Monetary Policy Committee voted to reduce the target for the stock of UK government bond purchases (or gilts) from the current £875 billion target to £855 billion7. It might be seen as somewhat odd if the Bank continues with its QE purchases while also hiking rates, so there is a good chance that planned purchases will also be cut in the coming months.
Moreover, the Bank has also linked the outright reduction of its balance sheet (i.e., quantitative tightening) to the path of interest rates going forward. In August, the Bank announced that when Bank Rate has risen to 0.5%, the MPC intends to reduce the stock of its purchased assets by stopping the reinvestment of maturing gilts. In itself, this could reduce the Bank’s balance sheet by just over £70 billion in 2022-23 and a further £130 billion over 2024-258. Furthermore, the Bank will consider actively selling some of its stock of asset purchases once Bank Rate has risen to 1%.
The Bank has made clear that decisions to stop reinvestment of maturing bonds and pursue active sales will depend on the economic circumstances prevailing at the time, and policymakers have also played down the potential impact of reducing the Bank’s balance sheet. However, this ‘two-pronged’ monetary tightening (rate hikes and balance sheet reduction) will take the Bank into unchartered territory. In terms of precedent, we have to look to the US experience, and it is worth noting that when the Federal Reserve (the US central bank) conducted simultaneous rate hikes and quantitative tightening back in 2018, it ended up ushering in a period of financial market volatility which ultimately forced policymakers to change tack and start loosening policy again in 20199,10.
Interestingly, the markets – which admittedly do not have a great track record of predicting policy moves - now appear to be betting that the BoE will overdo it on the tightening front and will be forced to start cutting rates again from 2023 onwards. Current market pricing suggests Bank Rate will rise to around 1.3% by the end of 2023, before falling back to 0.9% by the end of 202611.
4. Government debt servicing cost are now more sensitive to rising interest rates
Another consideration, which might have a bearing on how far rates rising during the next cycle, is that, as a result of the Bank’s accumulated QE holdings of government bonds, government debt servicing costs are now more sensitive to changes in Bank Rate. Under QE, when the BoE buys gilts, it pays for them by creating reserves which are held by commercial banks at the central bank. The Bank pays interest on these reserves at its policy rate, Bank Rate. The Office for Budget Responsibility (OBR) estimates that, as these reserves currently pay an interest rate of 0.1% – whereas the gilts they have in effect refinanced pay an average interest rate of 2.1% – the net interest saving for the public sector as a whole will be £17.8 billion in 2021-2212.
The problem is that, whereas prior to QE the long average maturity of UK government debt meant that changes in interest rates affected debt interest costs relatively slowly, now changes in Bank Rate have a more immediate impact on debt servicing costs. OBR estimates suggest that debt interest payments are now more than twice as sensitive to a rise in interest rates than they were prior to the financial crisis, with a one percentage point increase in interest rates increasing debt servicing cost by half a percent of GDP (around £13bn) within 12 months13.
This consideration should theoretically not have any bearing on the BoE’s decision to hike interest rates, given that it is independent from the Treasury. However, the response to the pandemic has blurred the division between fiscal and monetary policy, a point highlighted by a survey earlier this year that showed a majority of large bond fund managers thought that the principal aim of the BoE’s QE programme was to keep the government’s borrowing costs down14.
Taking all these factors into consideration, it would appear that, for whatever reason, the prospect of a rise in interest rates that takes real borrowing costs and savings rates back in to positive territory is a long way off.
15th November 2021