The Bank of England is on Thursday set to raise interest rates for the first time in a decade in order to keep a lid on inflation, a move that has the potential to hurt the British economy just as it struggles with the uncertainties of Brexit.
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The central bank is expected to lift its main interest rate by a quarter percentage point from the record low of 0.25 percent, taking back the cut it made in the aftermath of last year's Brexit vote to support the economy through the market turmoil of the time.
If it delivers the cut, as bank Governor Mark Carney has indicated, it would be its first hike since July 2007, when world credit markets started to freeze up in what would prove to be an early phase of the global financial crisis.
The main motivation behind an increase is to bring down inflation, which is running above the bank's target of 2 percent by a full percentage point and making life more expensive for households. Any further rise from the current annual rate of 3 percent would require Carney to write to Treasury chief Philip Hammond explaining why inflation is running more than a percentage point above target and what he and his colleagues on the nine-member Monetary Policy Committee are planning to do about it.
The reason for the spike in inflation is simple: Brexit. The pound plunged following the vote in June last year to leave the European Union, and now trades about 15 percent lower against a range of currencies. That has caused a spike higher in the cost of imported goods, notably food and energy.
Under normal circumstances, that would be more than enough reason to raise the cost of borrowing; higher interest rates can push up a currency, thereby dampening inflation by lowering import costs, and can also help cool an overheating economy.
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The dilemma for the Bank of England is that the British economy isn't showing any signs of overheating. Though unemployment stands at its lowest level since the mid-1970s and the main stock market in October hit a record high, the British economy is growing by less than any of the Group of Seven industrialized nations.
"Higher rates will be an unhelpful influence at a time when the economy is still struggling," said Samuel Tombs, chief U.K. economist at Pantheon Macroeconomics.
Though economic growth in the July-September period was slightly better than expected at a quarterly rate of 0.4 percent, the British economy has fared worse than the likes of Germany, Japan and the United States this year. Wages are also not rising as much as prices, meaning household finances are getting stretched, while credit growth has eased back over the summer. And inflation, in any case, is forecast to fall back next year as the lower pound's influence drops out of the annual comparison.
The worry is that by raising interest rates now, the Bank of England could further hobble an economy that's trying to steer the choppy waters of Brexit. Higher interest rates should in theory act as a dampener on household spending, even though the proportion of mortgage debt in Britain on flexible interest rates has fallen over the past few years, with more people opting for the security of fixed rates.
According to Oliver Harvey, a strategist at Deutsche Bank, a rate hike will have a direct financial impact on "a relatively smaller amount" of households than before the financial crisis. However, those that will be affected by a rate hike would suffer noticeably due to the fact that rates are so low — even the anticipated quarter point increase would mean a doubling in the interest rate.
Harvey also notes that many households are already burdened by weak income growth, low savings and high debt.
As such, the decision to raise interest rates is not expected to be unanimous, with some rate-setters opting for a cautious approach in light of all the concerns surrounding Brexit.
The country is due to leave the EU in March 2019, and there's no clarity on what the post-Brexit relationship between Britain and the EU, its main export market, will look like. Businesses are fretting about the lack of certainty and have urged the British government to swiftly conclude a transition agreement with the EU that will see the economic relationship remain in place for at least two years after Brexit. Goldman Sachs Chief Executive Lloyd Blankfein is one prominent business leader to have warned in recent days that his firm may relocate chunks of his business out of London to Germany's financial center in Frankfurt.
As a result, few economists think the Bank of England will embark on a quick sequence of rate hikes. ING economist James Smith expects Thursday's vote to be 7-2 in favor of an increase and says that anything less could expose divisions among the rate-setting panel that would rein in expectations of any further hikes next year.
"We expect the bank to continue talking up the possibility of further tightening this week, but with uncertainty elevated, demand sluggish and few signs of domestic inflation, we think the bank will tread carefully," said Smith.