What does the BoE rate hike tells us?


In ITS latest monetary policy meeting, the Bank of England’s (BoE) Monetary Policy Committee voted to raise its benchmark interest rate from 0.25% to 0.5%, reversing a rate cut made in August 2016, in conjunction with the Brexit referendum result.

It is the first rate hike in the UK in a decade, and since the global financial crisis struck the global economy and tipped the UK into recession.

The UK economy grew 0.4% quarter-on-quarter in the third quarter (3Q) of 2017, an increase on the quarterly gross domestic product of 0.3% recorded in the first two quarters of 2017.

The service sector, one of the dominant growth thrusts of the UK economy, grew by 0.4% in the 3Q, while manufacturing grew 1%.

The construction sector suffered its second quarterly contraction in a row. Even though the UK economy has improved on a quarterly basis, growth is still rather disappointing as annual economic growth is only at 1.5% in the latest quarter, slower than the 1.9% growth in the quarter before the Brexit referendum in June 2016.

The economy has been struggling to generate wage growth with the three-month average wage growth at 2.2% on a yearly basis and lagging behind the 3% inflation rate.

Rising inflation and sluggish wage growth will likely further suppress consumers’ spending power in the near term.

In most cases, the central bank would raise interest rates when the economy begins to overheat — that is when consumer and business demand is accelerating.

Looking at the UK economy today, one would hardly conclude that was the case here.

So, why did the BoE raise the interest rate? One reason is that the inflation rate has been above the BoE’s target rate of 2% for this year.

The higher inflation rate is mainly attributed to the depreciation of the pound that occurred since the Brexit referendum. The central bank will need to raise rates to curb inflation.

In addition, higher interest rates tend to give the bank more bullets to cut again if it needs to.

As rates now are at or near a record low, the possibility and ability for the bank to cut further will be limited.

We think the BoE is being mindful in managing the risk of a hard Brexit, as uncertainty over the UK’s future trading relationships, regulations and migration policy have led many firms to put their investments on hold.

All in all, the uncertainties associated with Brexit are weighing on the UK economic activities.

The increase in the benchmark rate is not a sign of the UK economy overheating, rather a necessary measure for the BoE to combat rising prices.

Given the economy is consumption- driven, the increase in rates will hurt consumer spending and weigh on the economy.

If the central bank does not act on inflation now, it might go even higher and eventually be detrimental to the consumer sector.