Bank of England deputy casts doubt on market interest rate expectations

The Bank of England’s deputy governor for monetary policy has cast doubt on financial market projections that UK interest rates need to rise to more than 5 per cent to bring down inflation.

Speaking to an audience at Imperial College, London, on Thursday Ben Broadbent revealed tentative internal BoE modelling that suggested interest rates needed to rise from the current 2.25 per cent rate by much less than predicted by markets.

His words rapidly lowered financial market expectations of the peak interest rate by 0.2 percentage points. That will be helpful for the government, since it will help reduce the projected costs of servicing public debt in the coming medium term fiscal plan, due to be announced on October 31.

Lower market rates would also bring down mortgage costs, now averaging more than 6 per cent for a two-year fixed deal, according to research this week from Moneyfacts, a financial information company.

Broadbent stressed that the UK had to accept it was poorer following the sharp increase in energy prices over the past year and that efforts to offset this — whether through government support, battles for higher wages or price increases to protect profit margins — would all be inflationary and force the BoE to raise rates further.

But he expressed some doubt over the futures market, which predicted the central bank would need to raise the official interest rate to a peak of 5.25 per cent by next May. After he spoke this fell to 5 per cent.

“Whether official interest rates have to rise by quite as much as currently priced in financial markets remains to be seen,” Broadbent said.

The deputy governor’s remarks are unusual because the central bank rarely comments directly on whether financial markets are correctly interpreting its internal thinking.

In this speech, however, Broadbent went even further and published internal BoE modelling of the “optimal” interest rate response to reduce inflation from 10.1 per cent in September to its 2 per cent target. It looked at the rate rises required to offset the inflationary effects of the government’s energy price guarantee and sterling’s recent depreciation.

The calculations showed that since the BoE’s August forecasts, these government measures — excluding the unfunded tax cuts in the “mini” Budget — would require additional interest rate rises peaking at 0.75 percentage points.

Broadbent compared that increase with the market’s expected increase of 2.25 percentage points.

While acknowledging everyone should take this comparison with a “heavy dose of salt”, and that the market had also moved in response to inflationary wage and price data, the deputy governor used the example to question whether market predictions were too high.

“The graph does serve to illustrate quite how significant the moves in markets have been in the past couple of months or so,” he said, adding that raising rates to over 5 per cent would imply a large contraction in the UK economy. That would be more than the BoE thinks is necessary to bring inflation down to its 2 per cent target.

However, Broadbent stressed that no one in the UK could avoid the pain of higher oil and, particularly, gas prices. “Import prices have risen significantly compared with the price of UK output. This has unavoidably depressed real incomes,” he said.

Finally, he warned that if people and companies tried to resist the consequences of soaring energy costs, no one would be better off because inflation would stay high for longer and interest rates would have to rise further.

“It’s understandable that employees and firms should want compensation for these losses, by raising wages and domestic prices,” Broadbent said. “Unfortunately, and at least collectively, these efforts will not make us better off. The effect is to raise domestic inflation with no ultimate impact on average real incomes.”

Additional reporting by Tommy Stubbington