Interest rates have not peaked

Persistent core inflation and a recovering economy mean further hikes are likely.

Illustration by Gary Waters / Ikon Images

The Bank of England has raised interest rates from 4 per cent to 4.25 per cent today, the 11th consecutive rate increase since December 2021, to continue the steepest programme of rate rises in recent history. This will increase the cost of mortgages and rents, depress wages and make it more expensive for businesses to borrow – but it is highly unlikely that this is the last rise of the current cycle.

Expectations of further increases had been reduced by the failure of Silicon Valley Bank (SVB) and its UK subsidiary. SVB’s management failed to manage the risk of sharply rising interest rates, which led to severe losses and a bank run of unprecedented speed and size. Other mid-sized US banks and a major European bank, Credit Suisse, failed as the financial sector was drawn to the brink of a full crisis.

However, as the latest inflation figures released by the Office for National Statistics yesterday show, central banks have little choice but to continue applying pressure. Inflation as measured by the Consumer Prices Index (CPI) rose to 10.4 per cent in February. The increase in the headline rate was driven by the food prices, particularly vegetables, which have been driven up in price by poor weather and shortages.

There is nothing the Bank’s policymakers can do to encourage rainfall in the parts of North Africa where our tomatoes are grown. However, the spike in food prices was accompanied by a rise in the less volatile “core” inflation, and that is a very significant concern, because core inflation tends to reveal the overall medium-term trend.

The economist and banking expert Frances Coppola says the rise in services inflation is also a concern, because very often the main cost of a service is the pay of the person providing it. “That implies that we have wages rising quite fast in the services sector,” Coppola explains. “That is a worrying sign – it does suggest that some kind of wage-price spiral is developing.”

Coppola says a growing number of people in the UK will feel the results of today’s rate rise immediately, because fewer people are locking in to fixed-rate mortgages while rates are high. This may well be sensible in the long term, but it means that in the coming months, homeowners and renters (whose landlords are often on floating-rate mortgages) will see an “immediate pass-through” from Bank rate decisions into their monthly bills.

Nevertheless, Coppola predicts, “there is more to come” on rate rises.

Tony Yates, former head of monetary policy strategy at the Bank of England, says that while the Bank has to react to “stubborn” core inflation, the end for interest rate rises is approaching because the “momentum” of inflation is downwards: “To perpetuate what we were experiencing, energy prices would have to keep going up, and they haven’t – they’ve fallen a lot.” Yates adds that the recent volatility in the financial sector will “weigh down on confidence, and bank lending”, which will compound the effect of higher central bank rates in reducing demand (and therefore inflation).

Higher and more durable interest rates may also, as today’s report from the Bank’s Monetary Policy Committee (MPC) shows, be the result of some better news for the UK economy. The MPC now agrees with the Office for Budget Responsibility’s forecast, released alongside the Budget last week, that the UK will narrowly avoid a technical recession this year. The Bank also reported that “the UK banking system maintains robust capital and strong liquidity positions”, implying it believes that despite the recent turmoil, Britain’s banks can take the heat of higher rates.

That said, this is a time of uncertainty. As we have seen in the wake of last year’s “mini-Budget” and in the SVB crisis, swings in the cost of borrowing can have unforeseen, sudden and very serious outcomes. Were the rises in the UK and US this week to cause widespread liquidity problems in financial markets then rates would drop, says Yates, “like a stone”.