The Bank of England is in no hurry to increase interest rates while the outcome of the Iran conflict remains uncertain and the UK's economic growth stays sluggish, according to Governor Andrew Bailey.
Current Policy Stance
In a clear indication that borrowing costs will stay at 3.75% at least through the summer, Bailey stated that it is acceptable for inflation to exceed the Bank's 2% target during the current crisis. However, he cautioned that this tolerance would diminish if a more permanent rise in prices began to take hold.
"Given the context of softness in the real economy and uncertainty around the scale and duration of the shock, tolerating temporarily above-target inflation to provide some support for the real economy is an appropriate way to approach the trade-off between inflation and activity," Bailey explained. "But that tolerance would weaken if signs of second-round effects begin to emerge."
Market Expectations Shift
At the start of the year, financial markets anticipated that the Bank would cut interest rates twice in 2023, bringing them down to 3.25%. Since the onset of the Iran war, expectations have reversed, and markets now forecast a 0.25 percentage point increase to 4% before December.
Speaking at a conference in Reykjavik organized by Iceland's central bank, Bailey noted that the economic situation has deteriorated since the bombing of Iran by the US and Israel began. "We have to monitor the situation in the Middle East and how it affects the UK economy and inflation very closely and adjust policy as required," he said.
Global Central Bank Responses
Central banks worldwide are grappling with the surge in energy costs triggered by the Iran war. The Federal Reserve, under pressure from President Donald Trump, was expected to lower rates this year but is now predicted to hold steady after new Chair Kevin Warsh took office on 22 May. Meanwhile, policymakers at the European Central Bank have signaled a likely rate increase in June after cutting rates more aggressively than the Bank of England before the conflict.
Reasons for Patience
Bailey highlighted that borrowing costs for homeowners and businesses have already risen without the central bank needing to adjust interest rates directly. Mortgage costs have increased since hostilities broke out as lenders reversed their expectations of rate cuts, dampening the housing market. Mortgage lending is influenced by interest rate swaps, which have risen over the past month, reflecting predictions of upward rate movements.
Hedge funds and other financial institutions lending to businesses have also hiked borrowing rates. "We have, in effect, tightened policy in my view," Bailey said. "I was quite clear that I thought we probably would cut rates once or twice this year. That's off the table."
He noted a roughly 1 percentage point increase in the cost of new five-year fixed-rate mortgages, which represents a tightening of financial conditions. Additionally, the UK bond market has responded, with many hedge funds that are large bond buyers having overestimated the likely downward path of interest rates. This led to a significant reversal in their positioning, exaggerating the turnaround.
Fiscal Implications
Rising bond rates have also increased the cost of financing the government's £3 trillion debt load, although Bailey noted that this trend has eased in recent weeks. He acknowledged a hangover from the inflation spike in 2022 following the Russian invasion of Ukraine, which sent inflation into double digits. However, he said the central bank is now better prepared to assess the likely impact of rising energy costs on the economy and inflation, having adopted scenario planning.
The Bank now emphasizes the wide range of factors that could turn a temporary increase in inflation into something more permanent, making it unlikely to allow a repeat of the previous inflation surge without taking swift action, Bailey concluded.
