The U.K. economy is lagging behind the world, and the Bank of England says Brexit is having a “noticeable impact” on the economic outlook. That is a gloomy place to start from for a rate increase.
The BOE joined the Federal Reserve Thursday as a central bank pulling back on extreme policy, raising interest rates for the first time in more than a decade, to 0.5% from a historic low of 0.25%.
But the economic backdrop to the BOE vote is the mirror image of the U.S. and eurozone, where growth has picked up but inflation remains low. Brexit is the culprit. Without the destabilizing force of divorce proceedings from Europe, the U.K.’s trade-oriented, open economy should be benefiting more from the synchronized global growth that has characterized 2017.
But growth has slowed this year and inflation has hit 3%, well above the BOE’s 2% target. That has been down mostly to the big fall in sterling, as wage inflation is still proving sluggish. The central bank’s assessment that potential growth has taken a hit means that even with slower growth, higher inflation is harder to tolerate: therefore rates must rise.
The downgrade of potential growth relates mainly to weak investment, which may be exacerbated by businesses being cautious to spend as Brexit looms. A tight labor market—with unemployment now at a 42-year-low—is another factor that may limit further expansion. The central bank forecasts a small pickup in productivity, but to levels below that seen before the crisis. The potential pace of growth has thus come down to around 1.5%, the BOE thinks. This deterioration, not a collapse in demand from consumers, is the bigger worry now with Brexit.
The reaction to the BOE’s announcement—with the pound falling sharply, government-bond yields down, and U.K. stocks rising—suggests the market read this as a “dovish” move, similar to the Fed’s rate increases and the European Central Bank’s decision to cut back on asset purchases. The BOE removed a warning that rates might need to rise faster than the market thinks.
That might yet be unjustified; the BOE is still talking of further increases in rates, albeit with less urgency. If the market ignores that prospect too much, the BOE may yet be talking about another increase sooner than investors expect. But it will likely be an increase through gritted teeth, not something to smile about.
Write to Richard Barley at firstname.lastname@example.org