Who’s right in the interest rate debate?

The Bank of England (BoE) economists and the market seem to disagree about the impact of the Iran war on interest rates. Despite multiple BoE members stating they should (and will) be held steady, markets are pricing in three rate hikes this year.

Central bankers believe the danger of a slowing economy from the energy shock is just as problematic as the threat of price rises. The Monetary Policy Committee (MPC) is tasked with setting interest rates and its member Megan Greene said the BoE needs to “weigh the risk of inflation being pushed higher with the risk of demand being pushed much lower”. This view is supported by the governor Andrew Bailey, who said the “right place to be is on hold”. The Bank can only respond to what is in front of it, and given the sluggish UK economy, there is no reason to increase rates. All else equal, keeping rates steady is what “should” happen.

However, despite the economists’ insistence, the market doesn’t believe this is what will happen. Yields on UK two-year gilts, hit 4.53 per cent last week, up from 3.52 per cent at the end of February. These shorter-dated bonds are the most responsive to changes in monetary policy and, as the graph shows, have risen much faster than the government’s longer-dated debt.

Energy price rises are not necessarily inflationary in themselves. If consumers are having to spend more filling up their cars then they will have less to spend on everything else, dampening demand. That situation, though, puts pressure on the government to step in with broader support.

Since Covid, the electorate has become used to governments bailing them out with populist policies. Liz Truss’s record-short tenure as prime minister in 2022 is remembered for the unfunded tax cuts she pushed through in her surprise ‘mini-Budget’. What is less often recalled is that she paired this with a universal energy subsidy that cost taxpayers more than £100bn. Truss could have perhaps got away with a tax cut or a subsidy, but the combination was too much for the so-called bond market ‘vigilantes’.

The timing of her Budget was particularly bad as the UK was already coming out of a period of fiscal expansion. In 2021, government spending increased 25 per cent to cover the £229bn pandemic support for households and businesses, pushing the deficit to a peacetime record. Although this came down in 2022 as the economy reopened, the deficit remained above the pre-pandemic level.

The Bank of England did not respond to this government stimulus with interest rate hikes because, after years of low inflation, the threat of price rises wasn’t at the front of its mind. This was a mistake: annual UK inflation hit 5 per cent at the start of 2022, even before Russia’s invasion of Ukraine added the energy price shock. Only then, when the BoE was already behind the curve, did it start increasing borrowing costs.

Inflation is not caused by either fiscal policy or monetary policy; it is the result of the dynamic between the two. Central banks are supposed to act as a homeostatic damper on the inflationary effects of fiscal spending. But as economist Scott Sumner explained in his recent blog post, this mechanism can fail as banks are often biased against making the same mistakes from before. This leads to overcorrection, as happened during the pandemic.

The MPC would have been pleased to hear chancellor Rachel Reeves rule out universal support for energy bills. Speaking to the House of Commons, she specifically referenced the Truss government, saying it “pushed up borrowing, interest rates, inflation and mortgage costs with an unfunded, untargeted package of support”. However, maintaining this position under political pressure will be hard. The left-wing Green Party leader Zack Polanski is already using the energy shock to attack the government, calling it an “unbelievably weak response” from the chancellor.

If the government does eventually cave to pressure from the left to spend more, as it has done several times since coming to power in July 2024, the Bank of England will react, and the market expects that to include multiple rate hikes.

This more hawkish expectation for the bank is in line with Sumner’s view that the response of central bankers and subsequent inflation is dependent on “the attitude of monetary and fiscal policymakers toward growth in nominal spending”. After the pandemic, central bankers were happy for growth (and accompanying inflation) to go relatively unchecked after a decade of stagnation following the 2008 recession. But now the zeitgeist has shifted; inflation is the biggest fear.  

For now, the Bank of England will stick to its guns; it is right that energy shocks alone are not particularly inflationary. The market, though, isn’t buying this story. It knows this age of political populism won’t allow it.