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The Bank of England should not raise rates yet

The arguments for and against the Bank of England raising its policy rate this Thursday are finely balanced. But ultimately members of the central bank’s Monetary Policy Committee should hold off and wait. While inflation has risen, and is likely to continue rising in the short term, the longer term outlook is unclear. Premature withdrawal of support could imperil the still-fragile recovery from the pandemic, especially as fiscal policy will tighten next year, too.

On its own, the 15 basis-point increase investors are expecting would merely bring the BoE’s base rate up from the lowest-ever level of 0.1 per cent to the second lowest level on record of 0.25 per cent. That will neither dramatically slow down the economy nor bring inflation to heel. It would, instead, send a message to markets, consumers and workers that the central bank takes the risk of rising inflation seriously. The central bank, however, would be unwise to send a signal using policy that is not justified on its own merits; there is no surer route to sacrificing its credibility than such game playing.

Inflation in the UK is slightly more than 3 per cent, and could rise to as much as 5 per cent next year. That is firmly above the central bank’s 2 per cent target and would, on its own, be a strong argument for the central bank to begin scaling back its monetary stimulus. The pandemic programmes were introduced at an extraordinary time and were intended to be of a size and scale to respond to that unprecedented emergency, which has now, for the most part, passed.

The bounceback has been much stronger than the BoE originally expected. Employment has recovered swiftly from the depths of the pandemic, returning to similar levels as in 2018 when the central bank last increased interest rates. Instead of the prospect of deflation facing the world economy last year, consumers and businesses alike are now expecting price rises to continue. This increase could become, devastatingly for a central bank, self-fulfilling.

On the other hand, the surge in inflation is partly due to temporary factors and the unusual pace of the recovery from the pandemic. Outside of a few in-demand professions — such as truck drivers — there is little sign of across-the-board wage increases. National income is still below its pre-coronavirus peak and it is too soon to treat predictions of long-term scarring as set in stone. Further potential outbreaks, as well as the mere possibility of flare-ups, still have a chilling effect on activity. Fiscal policy will, from next year, have a damping effect on growth as a set of tax rises on workers and businesses comes into effect. That could leave the BoE having to do more.

While the outlook is uncertain, the BoE needs to take inflation seriously but not rush to raise rates to prove its credibility. Markets will, and should, take a decision to leave rates on hold as a delay rather than an ongoing commitment to loose monetary policy.

Instead, the MPC can highlight that the central bank will soon arrive at its pre-announced target for asset purchases under the quantitative easing programme it launched at the start of the pandemic. That means it will stop buying gilts and corporate bonds and will, by itself, reduce the amount of support the Bank of England is giving to the British economy. It can also signal that — should it see the need to begin tightening — it will not fully reinvest maturing bonds, allowing for a smooth and unhurried reduction in its balance sheet over time. Raising rates or outright selling bonds runs too much risk of going too far, too soon.

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