Lancaster University economics expert John Whittaker explains why an impending interest rate hike is needed to keep the UK economy on track

The Bank of England was generally expected to raise its official key rate slightly on November 4, but decided to stick to the historic low of 0.1%. However, the Bank has made it clear that a hike is needed soon, and recent mortgage rate hikes indicate lenders are on board. So why the decision to wait?

The Bank of England is well aware of the distress that rising rates are causing for borrowers and, in particular, for the country’s biggest borrower: the UK government. At the current level of the national debt, around £ 2 trillion, each rate hike of one percentage point increases the interest paid by the government on its bonds by £ 20 billion a year over the long term.

Higher rates also have a dampening effect on the prices of real estate and financial assets such as stocks. Indeed, this is one way monetary policy is supposed to work: if people feel less rich, they spend less and it relieves the pressure on inflation.

In contrast, what is bad for borrowers is good for savers. As rates rise, bank deposits will be better rewarded and even the finances of our beleaguered pension funds should start to look healthier.

But it doesn’t matter who wins and who loses from higher interest rates, inflation is on the rise. The Bank does not want to lose credibility by letting it rise too much before tightening its monetary policy.

The inflation dilemma

After rising over the past 12 months, UK inflation is currently 3.1%, and the Bank even expects it to hit an uncomfortable level of 5% by the start of the year next, well above its 2% target. Yet the Bank maintains that this higher inflation will prove to be temporary, arguing that it will fall back as excess demand for post-Covid goods subsides and supply bottlenecks are resolved. On the other hand, energy prices are expected to remain higher, in part because of climate initiatives; and if employers continue to have difficulty filling vacant positions, higher wages will also tend to drive up prices.

At the end of the day, no one really knows where inflation is heading, so the Bank is grappling with the usual dilemma: is it raising rates now to prevent future inflation, or is it keeping rates low to prevent future inflation? to avoid jeopardizing the economic recovery while hoping that inflation will subside on its own? He can’t go both ways.

This same dilemma is found in other countries. In the United States, the situation is just as worrying, with inflation already at 5.4% against a target of 2%. Yet the Federal Reserve also continues to insist that the current high inflation is temporary, thus justifying keeping its official interest rate (the federal funds rate) close to zero.

Yet the Fed is not completely sitting on its arms; he announced that he would begin to “scale back” his quantitative easing (QE) program, in which he creates US $ 120 billion (£ 89 billion) per month to buy US government bonds and other financial assets to support the economy. From mid-November, it will reduce that amount by US $ 15 billion each month. It is at least an acknowledgment by the Fed that its overly stimulating monetary policy must eventually come to an end.

Back in the UK, the Bank of England amassed £ 800 billion in public debt as a result of its own purchases of QE assets, designed to boost demand especially since the Covid outbreak. At some point, the Bank will have to start offloading this debt.

Its choices as to when and how to proceed present the Bank with arguably an even greater dilemma than the discount rate, as the unwinding of QE will increase bond yields, thereby directly increasing interest costs for the Bank. the government and all other long-term borrowers.

In fact, yields have already started to rise after many years of falling (see chart above). It’s a sign that investors believe monetary policy needs to get tighter to curb inflation (by raising official rates and reversing QE) – which is also why mortgage rates have already risen.

All of this confirms that the long era of ever cheaper finance is finally over. The future will be more difficult thanks to higher interest rates, or higher inflation, or both.

John Whittaker, Senior Lecturer in Economics, Lancaster University.

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