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Was the Bank of England's rate hike a mistake?

Tim Wallace
Mark Carney went to Liverpool last week to explain the rate hike to normal people outside the financial services industry – but while he was away, markets began questioning the wisdom of the rate rise - Bloomberg

Mark Carney’s career as a stand-up comedian might be on the rocks. He singled out a member of his audience in Liverpool last week as the only person who chuckled at his speech’s reference to Pure, a hit by his favourite Scouse band the Lightning Seeds.

Schoolchildren and students were among those present and perhaps their musical tastes do not match up with those of the Governor of the Bank of England. Even if some of the gags flopped, the event itself had a much bigger purpose.

Carney and his deputies had ventured beyond their usual stomping ground in an effort to meet real people. The aim was to explain the Bank and its actions in plain English.

As Carney said: “People are very interested in the drivers of the economy and they really want more information about it, but they actually think, overwhelmingly, that economists are terrible at describing these effects.”

This is not a new problem. Thomas Carlyle struck a chord when he called economics “the dismal science” in 1849. Even the host of the event in Liverpool’s St George’s Hall said the Bank’s inflation report, a crucial document outlining its assessment of the economy, might be “good for the insomniacs”.

The Future Forum was one of a range of efforts to explain economics and the Bank’s role more clearly.

But it is not just the general public to whom the Governor must explain himself. Bankers and traders are not sure they understand his latest move to raise interest rates either.

The Bank’s Monetary Policy Committee raised the base rate of interest from 0.25pc to 0.5pc earlier this month, the first climb in more than 10 years. Carney’s deputy, Ben Broadbent, is very clear about the reasons: “It makes borrowing a little more expensive, it adds a little bit to the reward for saving, and it just helps to begin to keep inflation under control. Inflation is not terrifically high, but at 3pc it is above our 2pc target so that is why we raised interest rates.” Central banking 101, you might argue.

And yet some in the markets still think the Bank made the wrong decision. Long-term interest rates fell on the announcement, which is the opposite of what one would expect. This indicates that investors do not think the Bank is serious about the need to raise rates over the coming years. Analysts at UBS fear this rate increase could be a mistake akin to the European Central Bank’s two rate rises in 2011, which overestimated growth and had to be quickly reversed.

John Wraith, the Swiss bank’s UK economist, says: “In our view that was a puzzling decision which isn’t supported by the economic fundamentals, and we are certainly not alone in thinking that. There has clearly been a collective head-scratching going on.” Carney argued that the economy’s supply potential had been diminished, meaning it can grow at a slower pace before it generates excessive inflation and has to be reined in by higher rates.

But Wraith is unconvinced, countering that it is impossible to say whether this is true as we do not yet know the future trading relationship with the EU.

“We definitely think they have taken an unnecessary risk which may turn out to be a policy mistake, if important areas like wage inflation do not accelerate,” he says. “If they do, and we get meaningful progress in the Brexit negotiations, and we start to see pick-up in some of these areas for us which are still a cause for concern, then in hindsight we might say it was pre-emptive but turned out to be an appropriate policy. At the moment the jury is out on whether it is a mistake.”

He points to clear warning signs of that in the gilt market. It is almost unprecedented for a major central bank to begin a tightening cycle and find two-year government bond yields are below its base rate – that is, markets are prepared to lend for two years at a lower rate than the central bank pays overnight.

One prior example was in the US when the Fed was almost at the end of a tightening cycle. The other was in 2011 when the ECB made its famous mistake. Martin Beck at Oxford Economics also says the Bank of England has “failed the credibility test”, as bond yields and the pound fell on the rise. The limited amount of economic data published in the two weeks since the rise has done little to convince markets that the Bank was right, he notes: “In the third quarter we had the strongest productivity growth since 2011. It is only one quarter but it goes against the Bank’s line that trend growth is suffering.”

Beck also notes the irony that productivity could be picking up just as the Bank and the Office for Budget Responsibility have conceded it is not bouncing back. Rock-bottom unemployment and lower immigration could encourage investment and boost productivity in the years ahead, he argues. Other official data in the past week have also failed to back the Bank of England’s case that lower spare capacity means the economy could overheat even at a low rate of growth.

“Productivity has gone up, inflation has not gone up, pay growth has gone down,” he says. “It doesn’t really support what the Bank did.”

Jean-Claude Trichet hiked the ECB's rates in 2011, but the moves were quickly perceived to be a mistake and had to be reversed Credit: DANIEL ROLAND/AFP

If the rate rise does turn out to have been premature, Beck thinks the Bank of England might try to talk its way out of the mistake rather than reversing it. “They could soften their language and make it clear they are not thinking of raising rates any time soon,” he says.

Not everyone agrees. HSBC economist Liz Martins thinks markets would be wrong to assume the rate rise is a one-off, and expects another increase in May. “Not taking this seriously risks making the same mistake as in August, when the market ignored the MPC’s warnings,” she says. “The market reaction was dovish despite the Bank of England clearly saying more rate rises are needed.”

The Bank’s estimate of a lack of slack in the economy, combined with its bullish forecast on wages, strong support on the MPC for the jump and the Governor’s note that his economic forecasts are based on two more increases in the coming years all point to more rate rises, she says.

The markets are as confused as economists. Before November’s rate increase, traders believed the most likely time for the Bank to raise rates next was May.