The Bank of England’s monetary policy committee (MPC) has voted to keep interest rates on hold at 3.75 per cent. No shock there, given the uncertainties generated by the Iran war, but until the launch of Operation Epic Fury, pretty much everyone thought the Bank would take another of its baby steps and cut interest rates again by 0.25 percentage points. The change highlights how policymakers, investors, businesses and households are holding their breath at the moment – and such uncertainty could weaken the economy even in the short term.
What was the vote?
The decision was unanimous at 9-0 to hold rates, indicating a firm decision to stay on the fence. (Actually that’s unfair, as it represents a degree of necessary caution until the situation grows clearer.)
Why have they done this?
Before the Iran war, the outlook for inflation returning to the MPC’s 2 per cent target was relatively benign. You could say that the worst of Trump’s tariff chaos was over, that economic growth was fragile but gradual and that wage settlements had been slowly declining.
Now, everything depends on how long the war will last. If it is over swiftly and the oil, gas and financial markets return to something like normal levels, then the rate-cutting will most likely resume. If the war drags on and causes ever more disruption and leaves energy costs – a pervasive force in any economy – higher, then some more difficult decisions will have to be taken.
What’s the worst case scenario?
Stagflation: a combination of stagnant economic activity combined with accelerating inflation. This would be especially worrying if the increase in energy and fuel costs ignited another bout of domestically generated inflation, driven by inflation expectations pushing wages higher; experience of the impact of Putin’s Ukraine invasion will have taught the Bank not to be too complacent about how easily inflation can run out of control. Indeed, the fact that consumers are even more “inflation conscious” now because of their recent traumatic experiences means that the risk of a price-wage-price spiral is greater, and rates will need to be higher than they’d otherwise be set.
What’s the best case?
Even if things don’t deteriorate, the Bank has the challenge of whether to “look through” recent pressure on inflation as a one-off – and tolerate drifting away from the 2 per cent target while the economy readjusts – or make a statement by firmly pushing rates up.
If members of the MPC remain nervous about Britain’s labour and skills shortages, and think businesses will want to be able to raise prices, they will have to take the painful decision to hold rates again or even increase them. (A technical alternative would be “quantitative tightening – selling UK government bonds to take money out of the system).
Investors are now pricing in a couple of rate rises this year, but it still depends on when the war ends. A lot of people hope the doctrine of Taco – Trump always chickens out – will again prevail.
What will all this do to the housing market?
It will depress it, lowering values and slowing sales. Mortgage deals are already scarcer and more expensive. Those on trackers will be denied the most windfalls they’d have been looking forward to from the MPC, and there’s a chance that rates could even rise. Coupled with lower growth in earnings it’s a grim picture – but maybe offers opportunities for first-time buyers.
And politics?
Fortunately, the Treasury under Rachel Reeves operates complementary fiscal and monetary policies of gradually pushing inflation lower while trying to promote growth. So policy will at least be coordinated. The more Reeves spends on emergency subsidy schemes, the less the Bank will wish to cut rates.
Interest rate rises, or further delays to cuts, would make Britain’s huge national debt more costly to service, reducing room for raising public spending or tax cuts. The government is also facing calls for help with energy bills for households and consumers, but with debt so high it’s more difficult to protect people from the full force of a surge in inflation.
In other words, a cost of living crisis could well intensify – bad news for the governing party. It is hard to blame Reeves and the government, but what voters will want is a sense that ministers are sympathetic and competent. Any missteps now would mean the end of Reeves’s career, and grim consequences for this first Labour government elected since 2005.
