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UK interest rates: to hike or not to hike?

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Charlie Diebel - Charlie is Aviva Investors’ Head of Developed Market Rates. With 30 years’ experience in the industry he plays a key role in driving innovative thinking across the investment team.

The rate of inflation in the UK has risen sharply in recent months, prompting speculation that the Bank of England may raise interest rates over the next year. Just two of the eight members currently on the Bank’s interest rate-setting committee voted for a rate hike at its 3 August meeting.

However, recent comments by some of the rate setters have fuelled speculation that borrowing costs could go up. One member, Ian McCafferty, recently called for two increases over the next two years, while another, Andy Haldane – the Bank’s chief economist – said monetary policy should be tightened before the end of 2017. On 28 June, the governor of the Bank of England, Mark Carney, also suggested interest rates could rise if business investment grows.

The sharp rise in inflation over the last year is mainly a result of the fall in the value of sterling following the EU referendum and much of the impact has now fed through. Nevertheless, the Bank says the decline in the value of the pound, which makes imported goods more expensive, is likely to keep inflation above its two per cent target throughout the next three years and that arguably gives it grounds to hike rates.

Wages not keeping up with prices

But given the uncertainty surrounding the UK’s economic prospects, it’s difficult to argue that interest rates should go up. Economic activity has already slowed notably this year from 2016. The rise in inflation is the key cause of the slowdown. Wages are not keeping pace with rising prices, leaving Britons with less to spend on goods and services, and consumer spending is the key driver of the UK economy.

Consumption fell at its fastest pace in four years in the second quarter of the year. Car sales declined in June for the third month in a row, providing more evidence of the pressures facing the consumer. People are also saving less than ever before, drawing on the money they have put by for a rainy day to finance expenditure.

The outlook for the economy is likely to remain unclear until the Brexit negotiations are completed in two years’ time. Even then, there may be a transitional period that could cloud the UK’s economic prospects for much longer.

Hiking rates, which would raise the cost of borrowing on mortgages and other loans, would undermine Britons’ finances, and hence the UK’s economic prospects, still further.

What might the Bank of England do?

Mixed messages from rate setters at the Bank reflect the lack of clarity on the economic outlook. Ben Broadbent, the Bank’s Deputy Governor, said on 12 July that he is “not ready to raise interest rates” due to there being too many “imponderables” in the economy. Earlier, Gertjan Vlieghe said a “premature hike would be a bigger mistake than one that turns out to be slightly late.”

That said, the Bank could simply decide to reverse the emergency rate cut implemented following the Brexit vote. That could be a means of signalling to the financial markets that the extraordinary monetary polices adopted by the Bank in the wake of the global financial crisis will not be in place indefinitely.

However, it is unlikely the Bank will embark on a major rate-hiking cycle, given this could have a severe impact with all the unknowns related to the economy over the next two years and more.

What does all this mean for financial markets? Investors in UK government bonds, known as gilts, already expect at least one rate hike over the next year, and appear to believe that two hikes are more than likely over the next two years. The stock market too seems fairly relaxed about the prospect of a modest rise in interest rates.

AR011013 08/2017

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