Interest rates, thermostats & mince pies!

In his latest blog, our Corporate Finance Director, Stephen Gregson discusses the rise in interest rates announced by the Bank of England.

I don’t know about you but there are certain constants in my life at this time of year – listening to too much Christmas Easy Listening on Spotify; rushing to be the first to highlight in the bumper issue of the Radio Times the films and programmes I want to watch (but rarely do); eating too many mince pies – and struggling to get the central heating thermostat set in its goldilocks zone of neither too warm nor too cool.

If we find the central heating tricky to manage we should spare a thought for the Bank of England’s Monetary Policy Committee (“MPC”) – the body which sets the Bank Base Rate (“BBR”). It has just had its most recent meeting and voted to increase the BBR by a factor of 150%! I know, that’s a huge amount – but we would do well to bear in mind the saying that there are lies, damned lies and statistics. Yes the BBR has increased by a factor 150%; but this is actually from 0.1% to 0.25%. A headline which says that BBR has increased by just 0.15% sounds far less scary but is arguably much more meaningful and accurate to the reader.

We all know why the BBR has increased; the last few weeks and months have seen the MPC regularly revise upwards its forecast of peak inflation in H1 2022. Only a month or so ago the peak was expected to be c 4.5%; it’s now expected to be c6%. The MPC has the task of managing BBR with the intent of helping long term inflation stabilise at 2% – but it also has to do this by keeping an eye on the impact of BBR rates on the wider economy; that’s quite a balancing act to achieve.

But what is driving the inflation spike? That is the question. It doesn’t seem to be oil prices (at the moment) but more Covid / post Brexit supply bottlenecks together with domestic wage inflation (again many see this as connected to Brexit and possibly also Covid impacts). But the weighting of these elements isn’t clear (to us or the Bank). And if the primary driver is external to the UK factors (ie we are importing inflation ) how can a UK base rate rise meaningfully impact these elements?

Also, we need to think about that BBR inflation rate forecast for 2022 and beyond (it is called a fan chart; take a look at any MPC report and you will see why). The Bank continues to see the spike as temporary and is expecting that it will steadily (potentially quite rapidly) wind down in H2 2022 towards a long erm norm of c 2% inflation. So, if the bank expects this inflation path why the need to raise the BBR now?

I think a large part of the answer to this question is down to psychology, signalling and trying to give the Bank some ammunition to be able to use Monetary Policy in the future more effectively.

What do I mean? Well, the 0.1% rate we have had is really quite peculiar – let’s be clear about this. That doesn’t mean it is wrong, but it is highly unusual for BBR to be that low. At those levels, the Bank is severely constrained by what it can do to stimulate the economy in a downturn (because it does so by reducing the BBR). You can’t reduce a BBR of 0.1% before very quickly you are into a brave new world of negative interest rates (albeit not that new for Japan) and that might open up a whole Pandora’s Box of policies hitherto regarded as highly esoteric – think Milton Friedman’s helicopter money.

To be able to reduce BBR to stimulate the economy the BBR needs to be high enough for any cut to be meaningful.

Now to the psychology and signalling. The MPC vote to increase the BBR (and interestingly there was only one vote against – group think perhaps?) may also be signalling to the markets, to UKHMG and to us as citizens that it is not being too sanguine about inflation or ‘asleep on the job’ (any reading of the MPC minutes to date will quickly disabuse you of that notion should you be labouring under it…). That it can and should be trusted to take the steps necessary (even if unpopular) to help maintain the resilience and robustness of the UK economy (albeit within the limitations of its overall obligation to target a long term inflation rate of 2%).

Again, let’s not underestimate how difficult that job is. By some estimates, a BBR change can take 18-24m to flow through and affect the ‘real’ economy. Given everything that has happened worldwide in the last 18-24m we could be forgiven for concluding that that might suggest that the MPC is facing a near-impossible task when it decides on BBR. Imagine that when you set your central heating thermostat now you had to have one eye on what the temperature might be next March.

So, is the rise in BBR the start of a return to ‘normal service’ in the economy? Possibly But as Chairman Mao said when asked whether the French revolution had been a good thing or a bad thing – ‘It is perhaps a little too early to tell’.