Interest rates rise again but Bank of England hints at a brighter future

<span>Photograph: Neil Hall/EPA</span>
Photograph: Neil Hall/EPA

It is going to be bad but not as bad as previously feared. Interest rates may be near their peak. Inflation will be close to zero in a couple of years. Recent shocks have damaged the economy’s supply potential. Those were the main messages from the Bank of England as it raised interest rates for a 10th successive time.

Threadneedle Street is still expecting a recession but a mild one by UK standards, and less severe than it was predicting in the immediate aftermath of Liz Truss’s brief period as prime minister.

In November, the Bank was pencilling in eight quarters of falling output and a peak to trough fall in gross domestic product of 3%. It now thinks the economy will shrink by about 1% over five quarters, lasting until early 2024. By comparison, the economy contracted by more than 6% during the global financial crisis of 2008-09.

One reason for the growth upgrade is that interest rates are not now predicted to rise to the levels expected in November. The Bank bases its forecasts on the path of interest rates in the financial markets, and these have come down markedly from 5.25% three months ago to just under 4.5% currently. Another factor has been the strength of the labour market, which has resulted in consumer spending being higher in late 2022 than forecast.

Two of the nine members of the monetary policy committee – Silvana Tenreyro and Swati Dhingra – voted to keep rates on hold at 3.5% but were outvoted by the rest of the committee. Even so, the MPC’s language was noticeably less hardline about the need for future rate rises. When the Bank raised rates in November and December, it talked about the need to act “forcefully” in the event that inflationary pressure proved persistent. The word “forcefully” has since been dropped.

The MPC is alive to the risk that strong wage growth will keep underlying inflation – which excludes fuel and food – higher than it would like. Even so, using market assumptions for interest rates, headline inflation will fall to 4% by the end of this year, 1.5% by the end of 2024 and just under 0.5% by the end of 2025. Given that the Bank’s job is to hit the government’s 2% inflation target, that suggests the MPC is on course to overachieve and, if its projections are right, may soon start coming under pressure to cut borrowing costs.

The Bank’s job is not being made any easier by the series of shocks that have hit the economy’s supply potential. In the years leading up to the global financial crisis, this was estimated to be rising at a rate of 2.5% a year. In the years after, that estimate was cut to 1.5%. In the three years from 2023-25 a combination of Brexit, the Covid-19 pandemic and the increase in the cost of energy have reduced the figure further, to just under 1%.

Weaker potential supply is manifesting itself in labour shortages, a reluctance by businesses to lay off workers and higher private sector pay growth than the Bank was expecting three months ago. There are some signs of the labour market weakening but the Bank is not yet convinced it is job done. Hence the latest rate rise, and its warning that there could be more to come.