Why did the BoE just hike? What happens next?
Trend growth has fallen
The BoE is in a difficult spot. Lower trend growth and a weaker pound mean that if it doesn't hike rates, inflation could remain above target. But if it raises rates too fast, the economy could be hurt should downside risks materialise.
Q. What happened today?
The Bank of England increased interest rates by 0.25% today to 0.5%. The last time the UK saw a rate hike was in July 2007; Gordon Brown was Prime Minister, the ban on smoking in public places had been introduced a few days earlier, and the first iPhone had recently been launched. The world has changed a lot in the last decade.
Seven members of the Monetary Policy Committee (MPC) supported a hike while two dissented.
The decision to raise rates was well anticipated by the market. The initial reaction was for both gilt yields and the pound to fall, as the Bank's Governor adopted a 'dovish tone'. In particular, the MPC's minutes removed the statement about expecting interest rates to increase faster than the market is pricing in.
Q. Why is the Bank of England hiking interest rates even though economic growth is lacklustre?
The Bank of England stressed in the press conference that although growth is weak by historical standards, it is not necessarily below trend. Weak productivity and poor demographics are depressing trend growth, keeping unemployment low. This is consistent with our own research that highlights the drag on growth from baby boomers retiring (see here and here). With Brexit uncertainties also slowing immigration, UK firms report elevated recruitment difficulties, despite weak economic growth.
Q. How many more hikes will we see?
The Bank of England was also keen to stress that inflation would not return to target unless interest rates were hiked further. They broadly agree with market expectations of another couple of hikes in the next three years. This is consistent with our own expectation of slow rate hikes. Expect the mantra of "limited" and "gradual" to be reiterated in the following days/weeks/months.
Q. What happens next?
The Bank of England is in a difficult position. As a result of a weaker pound and lower trend growth, if it doesn’t raise interest rates, inflation could remain sticky above target. But if it raises interest rates too much, it risks hurting the economy. This suggests the Bank of England will act cautiously.