The Bank of England is in an unenviable position. It has to “do something” but it only has one thing it can do.

The surprise 0.5% interest rate hike at the last Bank of England meeting in response to persistently high inflation to a base rate of 5%, has sent the rates market scurrying to reprice expectations of how many hikes are to come. The graphic shows the markets now expect UK rates to peak somewhere above 6% towards the end of the year.

The reason the Bank has moved is that inflation in the UK has proved stubbornly high (the worst in the G7) and the economy more resilient than expected. However, given the situation it is likely that the impacts of the rate increases have yet to be felt. Relative to the past, many houses in the UK are mortgage free and a lower proportion are on variable rates. However, around 1.5m households are set to come off fixed rate deals this year. For some this will be inconvenient, for others it will be ruinous. It’s less that the Bank of England making a policy mistake and more which policy mistake it is choosing to make.

There are several reasons why the extent of the rapid rise in rates may, in the fullness of time, prove to be a mistake. Firstly, the impact of the rate increases are disproportionately felt by the relatively poorer and relatively younger cohorts. The older, wealthier sections of society actually benefit from the higher rates through increased interest income. In an already polarised and unequal economy, the hard working, cash strapped mortgagee, who has just been told by those in power they can’t have a pay rise because it is driving inflation, may be justifiably upset.

Secondly, in both the short-run and the long-run, it is possible that the rate rises are actually adding to rather than containing inflation. In the short-run, much of the government spending on things like pensions, entitlements and other public spending are themselves directly linked to inflation. In addition, the higher government debt interest payments effectively creating a wider fiscal deficit, which is also inflationary. In the long-run, whereas the link between interest rates and consumption is tenuous, the link between interest rates and investment is rock solid. As rates rise, investment falls which in turn constrains future supply which is also structurally inflationary.

Finally, high levels of debt across all sectors of the economy mean that the financial stability of the entire economy is at risk. Let us not forget that in the Autumn of 2022 the Bank of England was desperate to contain the increase in yields across the curve in the wake of the ill-fated Truss budget. These risks were highlighted concisely in the recent Bank of International Settlements Annual Report.

“Meanwhile, financial stability risks loom large. Public and private debt levels, and asset prices, are much higher than in past global monetary policy tightening episodes. To date, pandemic-era excess savings and a general lengthening in debt maturities during the low-for-long era have masked the effects of higher rates. But these buffers are rapidly depleting. As they become exhausted, growth could slow more than currently expected.” Augustin Carstens, General Manager of the BIS in AGM.

The Bank of England is in an unenviable position. It has to “do something” but it only has one thing it can do. In the fullness of time, whatever it chooses to do today, will with hindsight, look like a mistake.