Britain’s new prime minister is planning a political standoff with the Bank of England that economists believe will lead to a rise in interest rates before Christmas.
Liz Truss’ plans for generous energy subsidies will stimulate the economy, lower measured inflation and help households maintain spending levels, but this will likely force the central bank to hike rates faster to keep inflation under control.
Financial markets are betting that the bank’s official interest rate will rise to over 3 percent in December from the current 1.75 percent, a jump expected to shock households and businesses.
There will be three Monetary Policy Committee meetings before Christmas, the first on 15 September. Allan Monks, UK economist at JPMorgan, said: “It looks increasingly likely that the BoE will announce a 0.75pp rate hike next week.”
Allies of Truss has hinted it will announce on Thursday a plan to deal with rising energy bills based on a freeze on energy bills at a level of £2,500 a year, which is larger than economists were expecting. The BoE did not factor in new support in its August forecast.
Freezing energy bills would prevent inflation from rising well above the 10.1 percent level reached in July, but the BoE believes the economy will need to go into recession to bring it down sustainably.
Big fiscal stimulus would mitigate the chances of a recession, Monks added, but that “would likely make the economy and jobs more resilient than the BoE had anticipated in August and put more strain on the bank to try to lower inflation through higher interest rates “.
He said monetary and fiscal policies are likely to “collide”.
In a tough speech on Monday, Catherine Mann, one of the outside members of the bank’s MPC, said rate hikes would have to be “rapid and forceful” to show the BoE is serious about its inflation target. That’s better, she said, than relying solely on economic weakness to bring down inflation.
Kwasi Kwarteng, who was appointed chancellor on Tuesday, told the Financial Times this week that “coordination between monetary and fiscal policies is crucial.”
However, economists believe that this will be almost impossible to achieve if the government tries to stimulate spending while the BoE tries to dampen demand.
James Searle, Citi’s European rates strategist, warned that “fiscal and monetary policy will now move in different directions in the UK”.
Searle added that the developments are “worrying” because the Treasury Department’s policies contradict those of the central bank and “also point to a fundamental mismatch in the analytical framework of the central bank and the Treasury.”
With the BoE having the final say, Searle predicted that “the MPC will respond to further fiscal easing with increasing aggression”.
Jonathan Portes, economics professor at King’s College London, believes this conflict is inevitable. “Trussonomics means more borrowing,” he said, warning that while increasing public debt was not a problem for the BoE when interest rates stayed near zero, it is not now.
“UK interest rates are well above their bottom and trending higher. Inflation, of course, is around 10 percent,” Portes said.
Truss, meanwhile, has become less aggressive towards the BoE as it has come closer to power.
In July, she wanted to review the BoE’s mandate and called on ministers to give the bank “a very clear monetary policy direction”. But this week she pledged her support for the bank’s independence, saying that “it is the job of the Bank of England to bring inflation down”.
Her comments will reassure Andrew Bailey, BoE Governor, and other bank officials that Truss and her Chancellor will not object to higher interest rates. The governor and his colleagues will appear before the House of Commons Finance Committee on Wednesday to present their latest thinking.
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