Bank of England's Interest Rate Should be Closer to 10% says Swiss Re

Interest rates and finance

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The Bank of England's basic interest rate should be set as high as 10% given the scale of UK inflation, according to a major international finance house.

Research from Swiss Re, the wholesale provider of reinsurance, insurance and other insurance-based forms of risk transfer, finds the Bank of England further 'behind the curve' than any other developed central bank.

The findings come in the wake of the Bank of England's decision to raise interest rates by a further 25 basis points in June, taking Bank Rate to 1.25%.

But the Bank could be moving too slowly if it is to achieve its aim of stabilising UK inflation back to the 2.0% area says Swiss Re.

As such, Swiss Re sees further hikes coming from all major central banks, including the Bank of England which cannot afford to be left behind by the likes of the U.S. Federal Reserve.

"The most significant central bank tightening cycle in decades has begun and we expect much more policy tightening to come this year and next," says Jérôme Haegeli, Swiss Re Group's Chief Economist.

"We believe central banks will press ahead with policy tightening even as growth slows, until there is a significant decline in inflation momentum," he adds.

The Bank of England has been accused by some economists of being more focussed on preserving UK economic growth than containing inflation, meaning it has not delivered interest rate rises in increments larger than 25 bp.

The May policy decision was notable in that the Bank signalled it was a reluctant hiker, fearing the economy was effectively about to stall.

But fast forward to June and the Bank appears to have realised its core aim is to fight inflation, even if that means stalling the economy.

"An aggressive new cycle of central bank tightening is needed," says Haegeli.

Swiss Re says it is not just the Bank of England that is "behind the curve" when it comes to raising interest rates.

"Approximations of an adequate interest rate policy, proxied by our estimates of the Taylor rule, suggest that almost all major advanced economy central banks are at least 2ppts below interest rate levels that would be warranted given the current economic environment," says Haegeli.

The Taylor rule is an equation that prescribes the central bank policy rate as a function of inflation and economic slack such as the output gap or the unemployment gap.

Taylor rule and central banks

Above: "Estimated adequate policy rate across economies vs current policy rate... the notable exception is the Bank of Japan who accepts Yen weakness currently." - Swiss Re Institute.

In the case of the Fed, the current environment would imply policy interest rates of around 7%, compared with 1.75% at present.

For the Bank of England a Bank Rate closer to 10% looks more appropriate.

The Bank of England will have little choice but to continue raising interest rates as long as the Federal Reserve continues at its current pace, meaning a 50bp hike at the August policy decision is highly likely.

Swiss Re explain that those central banks that are left behind risk seeing their currencies weaken, which only adds to inflationary pressure.

"So far most central banks appear unwilling to accept currency weakness, which adds to inflationary pressure.3 Since foreign exchange rates are also driven by interest rate differentials across economies, this implies a lower bar for central banks to enforce a tighter monetary stance," says Haegeli.

This is certainly the view of BoE Monetary Policy Committee member Catherine Mann who said in a recent speech the Bank should be more active in following the Fed to defend the value of the Pound and minimise imported inflationary pressures.

However the Bank of England is stacked with policy makers who remain concerned about economic growth and the odds of another 25 bp rise in August remain high as a result.

This would almost certainly be a negative development for the Pound given the market is now fully priced for a 50bp move.