In October, the Bank of England decided to raise interest rates for the first time in a decade – which prompted an unusual market reaction last week, with both the value of the pound falling sharply.
Adam Chester, Head of Economics at Lloyds Bank Commercial Banking, said “The sterling was noticeably softer, at one stage falling around two cents against both the US dollar and euro, towards $1.30 and below €1.12, retrospectively.”
Chester also added, “The unusual reaction to last month’s events stemmed, in part, from the fact that the Bank of England’s decision to raise interest rates by a quarter point had been so well flagged… While there appears to have been an element of ‘buy the rumour, sell the fact’ following the announcement, this doesn’t explain the extent of the reaction, which we believe is overdone. This seems primarily down to the Bank of England’s decision to omit a key line in the minutes that accompany the announcement.”
The economic projections that underpinned the Bank of England’s latest decision were conditioned on a market profile for interest rates that embodied two more quarter-point increases in UK Bank Rate, to one per cent, over the next three years – a view that we broadly share.
Admittedly, that would represent a very modest tightening, but it would be in line with what the market had been expecting prior to the announcement. Arguably, therefore, the reaction should have been limited. Instead, by the end of the week, money market rates had fallen to such an extent that only one more rate rise was being priced in by late 2020. We believe the markets and trends have misinterpreted the Bank’s signal.
If anything, we believe there was a stronger argument for bond yields and the value of the pound to have risen following the announcement, as even allowing for two more rate rises, the Bank still expects consumer price inflation to be above its two per cent target in three years’ time.
So, where do rates go from here? The answer is, as with most issues in economics, it depends. The degree of uncertainty surrounding the domestic economic outlook makes accurately forecasting UK interest rates over the coming years particularly difficult. This is compounded by the additional uncertainty of how the Bank of England will respond.
As evidenced again in last week’s projections, it is clear that the UK central bank is prepared to accept a prolonged period of above-target inflation as a price worth paying to ease the pressure on the economy. It is willing to do so due to the potential risks surrounding Brexit. As long as the Bank of England believes the economy has some spare capacity, it is likely to continue to attach disproportionate weight to supporting growth.
But it is doubtful that much spare capacity now remains. Unemployment is, after all, at a 42-year low of just 4.3 per cent and below most estimates of its natural rate.