The Bank of England’s Rate Hike Shouldn’t Have Been a Shock

The Bank of England surprised financial markets last week by raising its policy rate by half a percentage point instead of the expected quarter. The bigger surprise was that so many investors and analysts were surprised. With inflation stuck for a second month at 8.7%, much higher than in Europe or the US, the central bank’s new policy rate of 5% is still substantially negative in real terms. If the UK is to get inflation back down to its 2% target, this latest move is unlikely to be enough.

To its credit, the bank gave a thorough account in explaining its decision. It said headline inflation is bound to fall somewhat this year as earlier spikes in energy prices drop out of the numbers. But measures of underlying inflation have moved the wrong way. So-called core inflation rose from 6.8% in April to 7.1% in May, and inflation in the price of services rose from 6.9% to 7.4%. Although various temporary factors are doubtless involved, both these outcomes were worse than the bank had predicted.

Two other factors add to the risk that inflation is on course to settle well above 2%. First, thanks to a tight labor market and many unfilled vacancies, earnings are still growing rapidly — at an average rate of 7.6% in the three months to April, again higher than the central bank had expected. Second, inflation expectations, while falling from earlier peaks, remain elevated. Surveyed in May, consumers expected prices to rise by 3.5% over the next 12 months (down from 3.9% in February) and saw inflation lingering at 3% even after five years.

The latest increase in the policy rate, and the further increases that might yet prove necessary, certainly involve risk. The effects of interest-rate changes take time to work through. The Bank of England, like the Federal Reserve, was slow to see the risk of persistent inflation; there’s a danger it might now lean too far in the opposite direction.

Moreover, the complex channels through which tighter monetary policy affects financial conditions and the wider economy have changed since the bank last faced this challenge. In particular, many households now have mortgages with rates fixed for two, three, or five years; they took those loans when rates were close to zero, and are bracing for resets that will raise repayments, in some cases, to unaffordable levels. This could deliver a more abrupt shock than policymakers would wish. Even if the mortgage-reset crunch proves milder than many fear, higher interest rates undeniably increase the risk of recession.