Economy set for 5% hit if interest rates spiral

Raising interest rates to 5.25 per cent next year would knock nearly 5 per cent, or £114 billion, off the economy, the deputy governor of the Bank of England has warned.

Markets had anticipated British interest rates would peak at that level before Ben Broadbent’s speech yesterday. Rates stand at 2.25 per cent but are expected to rise to tame inflation.

The ratesetter said interest rates may not rise as high as investors are predicting. He cautioned that such rate rises could hit growth by nearly as much as the financial crisis of 2008, which cut GDP by about 6 per cent.

Financial markets lowered their expectations for interest rates after the speech. Investors are now pricing in an 85 per cent chance of a rise of 0.75 percentage points to 3 per cent at the next meeting on November 3, and a 15 per cent chance of a rise of a full percentage point to 3.25 per cent. The odds had been in favour of the latter until yesterday.

Broadbent, a former Goldman Sachs economist, said in a speech at Imperial College London that the “justification for tighter policy is clear”, but “whether official interest rates have to rise by quite as much as currently priced in financial markets remains to be seen”.

Inflation has returned to a 40-year high of 10.1 per cent, more than five times the Bank of England’s 2 per cent target, according to the Office for National Statistics.

Investors are now pricing in a lower peak in interest rates to take place later next year. The base rate is expected to rise to 5.1 per cent in June, rather than above 5.2 per cent in May, and to stay roughly at that level throughout 2023.

The yield on benchmark ten-year gilts rose by 3.31 per cent to 4 per cent after the speech on Thursday morning, but later fell after the news that Liz Truss would resign as prime minister. They stood at 3.76 per cent at 5pm yesterday.

“The pandemic raised the global demand for goods and reduced their supply; Russia has cut back severely its supply of gas to Europe. These have had dramatic effects on relative prices,” Broadbent said. “Import prices have risen significantly compared with the price of UK output. This has unavoidably depressed real incomes: the volume of output may have just about recovered to pre-Covid levels, but its consumption value has not.”

He added: “Because they’ve depressed real incomes, that slowing in demand will to some degree follow from the same rises in import costs that have pushed up headline inflation.

“Equally, if government support mitigates that effect, there is more at the margin for monetary policy to do. The [monetary policy committee] is likely to respond relatively promptly to news about fiscal policy. Whether official interest rates have to rise by quite as much as currently priced in financial markets remains to be seen.”

The Bank has implemented seven rate rises since December to take interest rates from a record low of 0.1 per cent to 2.25 per cent. Andrew Bailey, its governor, said last week that further rate rises would be needed at the next meeting, and Huw Pill, the chief economist, warned that they may need to be “significant”.

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Economy set for 5% hit if interest rates spiral