November 2, 2017 / 5:24 PM / a year ago

Breakingviews - Bank of England rate hike has dismal logic

The Governor of the Bank of England, Mark Carney, speaks at the Bank of England conference 'Independence 20 Years On' at the Fishmonger's Hall in London, Britain September 29, 2017. REUTERS/Afolabi Sotunde

LONDON (Reuters Breakingviews) - Raising interest rates is typically a sign of economic strength. The Bank of England’s decision to increase official UK borrowing costs for the first time in a decade has a more dismal logic. Governor Mark Carney and his fellow rate-setters have concluded that leaving the European Union will permanently lower Britain’s growth prospects.

Raising the UK bank rate for the first time since July 2007 should have been a milestone in Britain’s recovery from the financial crisis. In fact, the quarter-percentage point increase merely cancels out the cut that followed last year’s referendum. The rationale for changing course is more significant.

The central bank believes Brexit will hobble Britain’s growth potential. Leaving the EU will reverse some of the effects of globalisation that have put a downward pressure on prices and wages. Withdrawing from the EU single market will add friction to close to half of Britain’s exports. The UK will attract fewer immigrants, and companies will invest less.

Those shifts may ultimately enable British workers to demand higher wages. But low productivity means prices will also rise more quickly. The BoE reckons the UK’s potential output is growing by just 1.5 percent a year – below the 1.7 percent increase in GDP it forecasts for the next three years. In short, though the British economy is expanding at a slower pace than in the past, this may be unsustainable.

This analysis does not make raising interest rates now a foregone conclusion. Though inflation reached 3 percent in September and unemployment is low, there’s little evidence of wage pressure. Meanwhile, consumers’ incomes are being squeezed.

Carney sought to ease the pain by signalling that official rates would rise in line with expectations in financial markets – implying just two more quarter-percent increases by the end of 2020. The governor may also worry about the risks that a weak exchange rate pose to Britain’s ability to finance its current account deficit.

After the BoE last hiked rates, it was forced to slash them by 4.75 percentage points in the following 18 months as the global financial crisis tipped the UK into recession. The latest increase may also prove a mistake. As Britain’s political establishment stumbles towards a chaotic Brexit, however, the central bank’s dismal logic is hard to fault.


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