Bank of England’s Bailey: Interest rates hike may not be needed
The Bank of England may not raise interest rates in response to the Iran war and has already effectively tightened monetary policy by taking the prospect of future rate cuts off the table, governor Andrew Bailey has said.
In a speech in Iceland, the central banking chief said that inflation is “likely to go higher” as a result of the conflict in the Middle East but that the rate-setting Monetary Policy Committee (MPC) could ignore those higher prices if they do not filter through into wage bargaining and household expectations.
“Monetary policy generally looks through the direct effects of energy prices on inflation,” he said. “It takes time for changes in interest rates to affect the economy and inflation, so higher interest rates might only push inflation below [the Bank’s two per cent] target once the energy price shock has passed, resulting in undesirable volatility in both inflation and activity.”
The remarks are some of Bailey’s most dovish since the outbreak of the Iran war prompted the closure of the vital Strait of Hormuz shipping lane. The governor and other central bank officials had signalled at previous MPC meetings that the Bank of England was likely to raise its central interest rate were the conflict in the Middle East to stretch over several months.
But Bailey told the Reykjavík Economic Conference on Friday that despite the closure of the Strait stretching into its fourth month, a hike to the so-called Bank Rate may not be needed because of the weak domestic outlook for the UK economy.
“Continued weakness in the UK activity and the labour market is likely to lessen the strength of second-round effects from higher energy prices,” he said, “while recognising that these effects are likely to be stronger, the larger and more persistent is the rise in energy prices.”
Bank of England messaging shift effectively raised interest rates
Monetary policy officials are particularly wary of price rises from an energy shock might become embedded into an economy because they lead employees to bargain for higher wages, or leave a company for a better paying job.
This scenario – known as ‘second-round effects’ – can then develop into a wage-price spiral, whereby employers are forced to raise staff’s wages after a price shock in order to to prevent them from leaving, stoking more demand in the economy which could further push up prices.
But the Bank of England governor told delegates that protracted erosion of the labour market in Britain, which has seen job vacancies hit a five year low and unemployment hit five per cent, means that scenario is unlikely.
He also said that the sudden change in messaging from the MPC since the closure of the Strait of Hormuz had also had the effect of raising interest rates in the wider economy, even if the central rate remained unchanged.
Before the war, financial markets and mortgage providers had priced products and set borrowing costs on the assumption that the central bank would vote through three 0.25 per cent rate cuts over the course of 2026.
But by taking those cuts “off the table” the Bank of England has forced private lenders to withdraw loans and products the offered at the start of the year and price them differently, Bailey said.
He added: “We have already tightened policy considerably in response to the shock relative to what had been expected by markets. That is already affecting the economy. Key quoted rates on mortgages have increased since the onset of the conflict.”