Rising interest rates is a key pillar of Trussonomics. Liz Truss herself has always stopped short of saying this explicitly, pointing fingers instead at the Bank of England for its failure to curb spiralling inflation. But the economists advising her of lei have made clearin no uncertain terms, that they think interest rates have been too low for too long.
Right from the start of her leadership campaign, Truss was far more vocal about her criticisms of the Bank; a point made even clearer once she entered No. 10 and her di lei Chancellor Kwasi Kwarteng set up bi-weekly meetings with the Bank’s governor Andrew Bailey. With this new pressure being applied on the Bank, many thought it would make history today by implementing its first 0.75 percentage point increase since it gained independence.
Yet the Bank’s decision, announced at noon on Thursday, suggests the ‘pressure plan’ isn’t working as intended just yet. Rates were once again raised by 0.5 percentage points, taking interest rates to a 14-year high of 2.25 per cent. This is the seventh consecutive rate hike and the second time rates have gone up by 0.5 percentage points, though there was a distinct mix of views from the Monetary Policy Committee this time round: five members voted for another 0.5 percentage point rise, three voted for 0.75, and one voted for 0.25. All these options would have kept the headline rate relatively low in historical terms, and they go along with the consensus that the headline rate would rise once again.
In this sense, Truss’s plan for higher rates is still on track, but it is not moving at the speed that Downing Street would prefer. While much of the coming spending spree is a means to an end for the Truss agenda – deficit-financed tax cuts, for example – it is also intended to create breathing space for the Bank to raise rates: to shift towards looser fiscal policy and tighter monetary policy. Arguably it will be the next meeting of the MPC that reveals whether the government’s attempt to change this balance has worked. Then again, many will argue that the Bank is considering other factors than the government’s fiscal ambitions.
You can trace the Bank of England’s decisions as broadly following the Federal Reserve’s decisions – both clocked how wrong they had been to call inflation ‘transitory’ around the same time. However, the Bank is being less bullish (the Fed has been pursuing 0.75 percentage point rises, and did so again yesterday, while the Bank has been sticking with 0.5). The Bank may also be looking at a different set of signals from government. The MPC’s summary of its interest rate decisions notes that the government’s new ‘Energy Price Guarantee’ is likely to limit significantly further increases in CPI inflation, and reduce its volatility, ‘which could be interpreted as taking some pressure off the Bank to curb rising inflation , as the government itself has predicted its policy will reduce the CPI peak by four to five percentage points.
Its summary also makes clear that the Bank is expecting a formal recession. With the economy having already contracted in Q2, the Bank now points to evidence of ‘modest downside news to underlying UK GDP growth in 2022 Q3’, which if realized, would meet the technical definition of recession in the UK. MPC members will also be acutely aware of how rising interest rates might weaken an already-lackluster economy, leading to a steady but more cautious approach when voting for rate hikes.
But just as important as the Bank’s rate rise today is its decision to start engaging in quantitative tightening, with a unanimous vote to ‘reduce the stock of purchased UK government bonds, financed by the issuance of central bank reserves, by £ 80 billion over the next twelve months, to a total of £ 758 billion. ‘ There was speculation that the Bank might continue on with its money-printing program to help the government with its spending plans – but it seems the pandemic days – defined by mass-quantitative easing for crisis spending – have come to an end.
This may cause some pause in No. 10: one of Truss’s economic advisors suggested last month that over-correction of so much money-printing during the pandemic could also cause its own problems.
Markets seem to think we’re far from the end of rate rises, with expectation currently that rates will peak a little under 5 per cent. So the Truss government may well achieve its rebalancing act for fiscal and monetary policy. But so long as the Bank’s rate rises remain moderate, it’s going to take a long time to get there; and more time, too, to get inflation further under control.