Britain’s rate-setters appear to agree with an old English saying that a stitch in time saves nine.
The Bank of England (BoE) on Thursday became the first major central bank to raise its interest rate, hiking it to 0.25% from 0.1%. That’s a gamble at a time when economic recovery is fragile and there’s a new wave of COVID-19 infections. However, the old-school response to high inflation may ultimately pay off.
Pushing up interest rates used to be monetary policymakers’ traditional response to price pressures. The UK central bank now sees inflation peaking at around 6%, or three times its target, in April 2022 and isn’t the only one confronting this sort of problem.
However, BoE Governor Andrew Bailey is something of a trailblazer, even though American consumer prices are already rising at a faster pace than British ones are expected to reach next year.
There are a few reasons for this.
European Central Bank President Christine Lagarde faces less acute price pressures. As a result, she is more focused on ensuring that the yield gaps between German and southern European government bonds don’t blow out once her pandemic-era bond-buying programme winds up next March. Meanwhile, Federal Reserve Chair Jerome Powell has to consider the labour market alongside inflation. Finally, the Fed and the ECB have both tweaked their monetary policy framework in ways that make them more tolerant of temporary inflation overshoots.
The problem is that price pressures have lasted much longer than central bankers previously anticipated. The BoE’s rate rise is, therefore, a useful precautionary measure that could help keep public inflation expectations, and therefore wage demands, in check by showing that Bailey is serious about combatting price pressures.
By acting now, the BoE may therefore ultimately avoid having to raise rates faster or higher later. Money market prices show that UK interest rates are expected to peak around 1.25% by the end of 2023. By comparison, the median view of U.S. rate-setters is that their policy rate will be 2.1% in 2024 and 2.5% in the long run. Given that governments are more willing to extend fiscal support now than they were during the global financial crisis, central bankers are no longer left to do all the heavy lifting when it comes to supporting the economy. Bailey’s gamble is therefore one that’s worth taking.