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Why the Bank of England should tread carefully on interest rates

Suren Thiru is Head of Economics at the British Chambers of Commerce.

The Bank of England is widely expected to raise interest rates next Thursday for only the second time in the past decade with financial markets currently pricing in an 86% chance of a 0.25% increase. But at a time of heightened political and economic uncertainty, are they really doing the right thing?

The current remit for the Bank of England’s Monetary Policy Committee (MPC) as set out by the Chancellor of the Exchequer is two-fold – firstly, price stability as measured by a 2% CPI inflation target and subject to that, secondly, supporting the governments objectives for employment and growth. This means that the MPC often face a tricky trade-off between managing inflationary pressures and supporting economic growth.

However, currently the MPC is not facing such a dilemma, according to the latest data. The Q2 2018 BCC Quarterly Economic Survey - the UK’s largest and most authoritative private sector business survey – indicates that UK economic conditions remain subdued. While the modest pick-up in domestic activity points to a slight rebound in growth from a weak first quarter, there remains little evidence in the current data to suggest a sustained upturn in the UK’s economic growth prospects. Activity in the key services sector remains moderate, with most of the main indicators still below their pre-EU referendum levels. While still high by historic standards, the easing in export sales in the manufacturing sector points to a tightening in trading conditions. With growth in key markets moderating and the impact of the post-EU referendum slump in sterling dissipating, the improvement in the UK’s trade position in Q1 may well be short lived.

The number of businesses reporting that they are intending to invest fell in the quarter, and business confidence for both sectors also fell. If this weakness continues then economic activity is likely to remain under pressure in subsequent quarters. This is reflected in our most recent growth expectations for the UK economy. The BCC is currently forecasting UK GDP growth of 1.3% for 2018 which, if realised, will be the weakest calendar year growth in almost a decade – hardly the ideal backdrop for a rate hike.

So what about inflation? While UK inflation currently stands above target at 2.4%, it is on a downward trajectory. Indeed, once the impact of the pick-up in oil prices subsidies, inflation is likely to drift back to the 2% target sooner, rather than later. There also remains little evidence that higher inflation is becoming embedded in higher pay settlements, something that the Bank of England monitors closely.

With inflation on a downward path, wage growth sluggish and economic activity subdued, the case for tightening monetary policy next week remains close to non-existent. Despite this, the Bank of England seem set to press ahead with raising interest rates as it seeks to begin the process of ’normalising’ monetary policy. However, raising rates in the current economic and political climate risks undermining consumer and business confidence, weakening the UK growth prospects further. Indeed, history is littered with instances of central banks mistakenly tightening policy too early. For example, in 2011 the Europe Central Bank increased interest rates amid a worsening debt crisis, which then had to be quickly reversed.

Against this backdrop, the MPC’s focus should be on providing monetary stability, rather than adding to the headwinds currently faced by businesses and consumers.

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