Why Now is the Time to Raise Interest Rates at the Bank of England

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Berenberg's UK economist says raising interest rates at the Bank of England is certainly no policy mistake. 

The Bank of England will almost certainly raise interest rates at its meeting on Thursday and this is a good thing for the economy, says Berenberg’s Senior UK Economist Kallum Pickering who does not believe the Bank is about to embark on a so-called policy mistake.

Ahead of the November 2 policy update from the Bank - where markets assign a near-90% probability of an interest rate rise, there has been notable resistance to the move amongst some quarters of the economic commentariat.

The argument goes that the UK economy is slowing down and with Brexit uncertainty lying ahead raising interest rates will choke economic growth.

Fresh in the minds of economists and markets is the great policy mistake from the European Central Bank of 2011 when ECB President Jean-Claude Trichet and his team rose interest rates and promptly flat-lined the Eurozone economy.

Despite the Eurozone economy battling with high unemployment, low growth and sovereign debt crisis, the ECB raised interest rates in April and again in July eyeing rising rates of inflation.

European economic growth promptly stalled and the Eurozone’s debt crisis deepened. The question is whether the Bank of England is repeating a similar mistake in 2017?

Why the UK Needs an Interest Rate Rise

Despite many analysts questioning the validity of a rate hike due to growth slowing down to 1.6% this year from 1.8% previously, and much uncertainty from Brexit, Pickering is adamant a rate hike is a positive step.

The reason is that if left at their current low level, interest rates will encourage rampant borrowing which will store up a dangerously large pile of debt for the future, which households and businesses will not be able to service when interest rates start rising again.

In short, the BOE needs to raise rates to end an era of cheap borrowing.

"If left unchecked, households are set to borrow more than they can afford and save less than they will need for the future."

Impact of Brexit on 'Supply'

In addition, Brexit fears have reduced the supply of workers since many EU nationals are returning home or not coming, whilst the weaker Pound is less of an incentive for migrant workers.

This, in turn, is leading to supply constraints which could increase wages and combined with excess demand is further propelling inflation higher. 

"Meanwhile, uncertainty from Brexit seems to be weighing on supply more than demand," says Pickering, adding:

"Without higher interest rates, continued excess demand growth will cause domestic inflation to remain well above the BoE’s 2% target even as the temporary effects of imported inflation from a weaker sterling fade."

"By incentivising households to borrow less and save more, higher rates can take some steam out the inflation cooker," he adds.

There is little chance the BOE will disappoint on Thursday and not hike.

"Any chance the BoE won’t hike? Of course, there is always a chance. But it seems incredibly small," says Pickering.

His argument is that the BOE has had "ample opportunity" to set the market straight if it was having second thoughts about a hike since first raising the idea in June, and yet it has decided not to.

Then, of course, there is also the risk of a hit to the Bank's credibility if it were to back out now.

Multiple Hikes Seen

Whilst current market expectations are for a rise on Thursday and then one more interest rate rise in 2018, Berenberg sees two more hikes in 2018 and one in 2019 - which significantly more than the market.

"As long as the BoE goes early and slowly with its tightening we do not expect any major negative effects on real GDP growth or employment," says the Berenberg economist.

Forecast for Thursday's Meeting

Berenberg expects the BOE to raise interest rates by 0.25% at their meeting on Thursday.

They expect at least 6 of the 9 members to vote for a hike.

The accompanying statement and commentary to indicate that further subsequent rate rises will be at a "gradual pace and to a limited extent’ – in keeping with recent guidance.

They expect all members to vote in favour of keeping the bank's asset purchase programme unchanged.

Further, into the future they expect at least three more hikes in the next two years, and for the BoE to prepare markets for further rises.

This should precipitate a rise in gilt yields and Sterling.

If markets refuse to price in the higher rate expectations, as has happened so far, for Carney and other BOE members to suggest the market is underestimating the future path of rates.