Why did the Bank of England raise interest rates

And what does it mean?

What happened?

The Bank of England’s (BoE) 25 basis point interest rate hike was so widely expected that the announcements were something of an anti-climax. The markets were so ready for that 0.25 per cent rise, that the Pound registered barely a half a cent rise against the Euro in the few seconds following the announcement.

However, when traders saw the line on the statement that pointed to just two more hikes in the next three years, Sterling took a dive. The Pound began Thursday happily at €1.14 and US$1.33 respectively. By the time everyone had digested the statement and what it meant, with its dovish tones, the rates dropped down to €1.11 and $1.30.

Why did the exchange rates fall?

It is rare for a central bank to give such long term guidance. The fact that this particular guidance is so uninspiring has knocked the wind from the Pound’s sails in the short term.

What are the implications?

What it has also ignited is a cacophony of voices questioning whether there should have been any rate change at all and whether the BoE will regret being pre-emptive for perhaps the first time in its

20 years of independence. 

Why the rate hike?

The arguments for a rate hike were made by BoE Governor Mark Carney. His concerns over consumer inflation running above their outer limit of 3.0 per cent are certainly valid, but Sterling’s weakness in the past 16 months has been a major contributor to inflation, because it increases the costs of imported goods and the UK is a net importer, with a trade deficit of circa £170 billion per annum. 

The employment data would suggest wage rises were inevitable, but we are seeing average wage rises running well behind inflation at 2.1 per cent. That wages to prices inequality would normally cause a central bank to pause, but Mark Carney was pretty convinced we will see that gap narrow and the BoE is forecasting wages to catch up with inflation over the next two years.

What next? 

If that is to prove an accurate forecast, they will need to factor in higher energy costs, the impact of sterling’s slump after the BoE statement; and of course mortgage and loan costs will rise with this direction-altering base rate hike.

Consumers seem to know this. This week started with news of consumer credit data that beat expectations and that is certainly an argument for a rate hike, as is virtually full employment and a record number of people in jobs.

However, consumer confidence is still declining; as evidenced by an index reading of -10 this month and -9 last month. Business confidence is also being hard hit by the interminable Brexit rhetoric ahead of any meaningful negotiation progress. These factors combined certainly do not suggest a rate hike was urgently needed.

The fact that both borrowing and saving rates were lifted immediately after the BoE’s announcement has both good and bad impacts. Many borrowers are locked into low fixed rate deals on mortgages and most personal loans and car loans are at fixed rates. So, the impact of this rate hike will not be fully recognised for two years or more.

That is cold comfort for anyone with a variable rate mortgage. The percentage of mortgages that are in arrears is at the lowest level for a decade and the Council of Mortgage lenders is reporting the lowest number of repossessions since 1982; all suggesting there is capacity to absorb a small increase in the private mortgages market.

Maybe the BoE is sparing a thought for savers, though, who have received virtually no yield on savings for over a decade. This may be starting from a very low baseline but, by doubling the base rate, the BoE has virtually doubled their returns.

Ultimately, if the BoE was solely concentrating on inflation, then a base rate hike when the Consumer Price Index is at 3.0 per cent makes complete sense. Starting to increase the cost of borrowing in the period leading up to the UK’s exit from the EU throws up a whole heap of counter arguments – and that is one of the factors troubling the markets.

If UK data continues to confound the doom-mongers, then a slow, sustainable recovery in the Pound is on the cards. However, that will most likely be a backdrop to significant volatility as the Brexit negotiations trundle on.