UK Rates Rise, Stagflation Beckons

Get ready for stagnant growth plus inflation...

LAST WEEK the Bank of England raised the key UK interest rate by a quarter of a percentage point to 0.5%, writes John Stepek at MoneyWeek magazine.

That's exactly what it was expected to do. It did so by five votes to four – in other words, five members of the nine-member rate-setting Monetary Policy Committee voted in line with market expectations.

However, what has rather taken markets aback is the fact that the other four – as you might assume – did not vote to keep rates at 0.25%. No, they voted to raise rates by a full half a percentage point, to 0.75%.

For perspective, this is still very near an all-time low. But from a different perspective, the UK bank rate is now five times higher than it was a scant two months ago (rates went up from 0.1% to 0.25% on 16 December last year).

Moreover, the Bank is going to unwind quantitative easing (QE). QE involves printing money to buy assets. Those assets – mostly government bonds – sit on the Bank's balance sheet. One key point about bonds is that they eventually mature; thus far, the Bank has been maintaining QE by reinvesting the proceeds of maturing bonds as they do so.

The Bank is now going to stop doing that. So, in effect, when government bonds held by the Bank of England reach their payback date, the government will need to find a new borrower to lend them the money to repay that loan (whereas previously it would just have "rolled over"). That'll amount to just over £70bn bonds during 2022 and 2023, and another £130bn over 2024 and 2025.

On top of that, the Bank is also going to sell off the corporate bonds that it has purchased.

Most importantly, the Bank's attitude has changed drastically. In November, markets were also shocked, but back then, it was because Andrew Bailey, head of the Bank, had led them to believe that a rate rise was a dead cert, then switched tack at the last minute.

Now inflation is public enemy number one again. It's expected to peak at 7.25% in April – remember, this is the CPI measure, so RPI could easily be just under double-digits by that point (here's what the difference between CPI and RPI inflation is, and why it matters).

That's even while the Bank is warning consumers that there are tough times ahead. It reckons that the squeeze on spending created mostly by higher energy prices (though it nods to the increase in National Insurance scheduled for April too), along with excess supply building up as supply chain bottlenecks ease off, is going to drive the unemployment rate up to 5% by the middle of next year.

Meanwhile, energy prices might stop contributing to higher inflation rates but only because they "are assumed to remain constant after six months". How realistic that assumption is is hard to judge, but even if energy prices remain where they are, that is quite the squeeze on consumer spending.

None of these things is inflationary in the sense of making the economy overheat. They are stagflationary, in the sense that prices rise but the price rises themselves choke off growth. If your energy bill goes up by 50%, that's money you can't spend on anything else; it does not boost demand in the economy.

The Bank even acknowledges this. "The sharp rises in prices of global energy and tradable goods of which the UK is a net importer will necessarily weigh on UK real aggregate income and spending. This is something monetary policy is unable to prevent."

So why is the Bank raising rates then? "The role of monetary policy is to ensure that, as such a real economic adjustment occurs, it does so consistent with achieving the 2% inflation target sustainably in the medium term, while minimising undesirable volatility in output."

I have to admit that this mostly sounds to me like pure self-justifying gobbledegook. The Bank will be told off for not meeting the 2% inflation target. By raising rates a bit, it can at least say "but we're trying".

Anyway – if you have a variable-rate mortgage, you'll notice the difference quite quickly, so maybe consider switching. If you have savings, you'll notice the difference rather more slowly I suspect, so it might be worth starting to shop around there too – though I wouldn't lock in any rates yet, given that more rises are apparently set to come.