Hostage to Fortune

November 4, 2022

This week, both the Federal Reserve (Fed) and the Bank of England (BoE) raised their rates. The Fed has now raised rates six times in a row, the fastest increase since the 1980s, and the benchmark lending rate now sits at 3.75-4%. For its part, the Bank of England announced its eight successive increase, a 0.75% rise – the largest increase since 1989 – to 3%.

You would be forgiven for thinking that this shows that the Fed and the BoE are singing from the same hymn sheet. Instead, while the tune might sound the same, these two central banks are singing in very different keys indeed. One is in tune with markets, the other is not.

The clues are in what the Fed and BoE are saying about the future. The Fed has been very careful this week to indicate that further increases in rates are necessary and that higher rates are coming, and that, in the words of Chairman Jerome Powell, “we still have some ways to go”. The Fed hinted that US rates would peak at a higher level than expected and that,“we will stay the course until the job is done”. These remarks echo Christine Lagarde’s comments in the last few days, who was categorical that a ‘mild recession’ would not tame inflation on its own. The message from Frankfurt and Washington is clear: the central banks will do what it takes in the future to get inflation down towards a 2% target.

Compare and contrast with the Bank of England: whereas Jerome Powell has been hinting as further strong action, Andrew Bailey had to remind the markets that the Bank of England “won’t follow the market”, and that “some repricing” was needed because the markets were wrong about where Bank of England interest rates might be. In the words of Duncan Weldon, the Bank of England’s monetary policy report included language “as close as I can imagine the MPC to shouting ‘we are not going to raise rates as much as you think we are’”. Often overlooked in the furore over the recent mini-Budget, one of the main reasons the markets were in a febrile state at that time was because the Bank of England was seen as being well behind the curve, adding to market worries at that time about the inflationary aspects of the mini-Budget.

Now, the Bank of England may very well be right that it will only need a rate of 3% (or close to it) to return inflation to target by 2025. But it could potentially be a highrisk strategy when many of its previous forecasts have, in the markets view, been proven wrong. It is even more bold in the context of previous attempts at indicating where rates might go in 2021 being so poorly received thanks to a number of communication mix-ups. The Bank now has a well-recognised communication problem.

To be fair to the Bank, it did state in its monetary policy reportthat it would respond forcefully if the outlook suggested more persistent pressures, and that there were considerable uncertainties. But if that is the case, why take such a robust view in its press conference?

The worry is that the Bank of England might get trapped in a game of chicken with the markets. The Bank does not want to raise rates, but the markets do not believe that the inflation target can be met without further hikes: who blinks first? That is not to say that the Bank’s view is incorrect. The Bank’s judgement may be right that the UK’s deteriorating economic position might reduce inflationary pressures enough to forestall too many more rate rises. But by communicating that markets are ‘mispricing’ interest rates, the Bank has invited market actors to disagree with it publicly about inflation, which they have already done. The one bright spot here is that mortgage rates do appear to have been cut after the Bank’s intervention, which suggests at least some sympathy for the Bank’s position.

One possible explanation here is that the mini-budget had very specific UK effects that drove interest rates up faster than they otherwise should have been, and that this effect has lingered. The Bank is necessarily constrained from commenting on fiscal policy, but its meaning was clear when the Governor said that there were ‘UK-specific components’ to the UK’s interest rate movements. As such, the Bank’s comments could be interpreted in part as an attempt to get any residual interest rate rise as a result of the mini-budget out of the system. Hopefully the fiscal statement will accomplish this in any case.

If the Bank of England’s forecast is correct, and that interest rates will only peak at 3 or 3.5%, this will be a relatively better thing for the UK economy, even if we are in recession.But in communicating its view so openly, the Bank has potentially made its credibility a hostage to fortune. To a certain extent, the Bank has put its aims in the hands of the markets.

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