MHA: Inflation landscape must improve by November to avoid rate hike

Emeritus Professor Joe Nellis is Head of Economic Research at MHA, the accountancy and advisory firm.

The expected decision by the MPC to leave interest rates unchanged at 3.75% provides some short-term relief for households and businesses. But after yesterday’s news of a rise in inflation in August, the odds are rapidly increasing of a rate hike when the MPC next meets in November.

The Bank of England is concerned that inflationary pressures are still with us and proving to be more persistent than previously expected. With inflation now well above the official 2% target, financial markets are factoring in a strong possibility of a quarter-point increase in the Bank Rate to 4%, especially if inflation continues to rise. Most importantly, if there are signs that higher energy and other costs are feeding through into wage demands, policymakers will see monetary tightening as necessary to stop inflationary expectations from becoming embedded.

This situation creates an uncomfortable background for the Government’s Autumn Budget. Already high due to elevated gilt yields, inflation will push cost of servicing the national debt up even higher. With the interest bill for this financial year already likely to be around £115bn, this further squeezes an already limited fiscal headroom. The Chancellor will need to convince financial markets that the state of public finances remains credible. Any unfunded spending commitments or fiscal giveaways could create a vicious circle and push borrowing costs even higher. With the Bank of England next meeting after the Budget, the Government must act in anticipation of its decision.

For homeowners, the prospect of higher interest rates means continuing pressure on mortgage borrowers, particularly those who are re-financing lower fixed-rate deals. Businesses also face higher financing costs at a time when investment and confidence are already fragile.

While interest rates have been held today, the critical question is what happens next, and how restrictive the Bank’s monetary policy may have to become.