What is going on at the Bank of England?

The governor of the Bank of England has finally hinted that interest rates will need to rise closer to 1% in the next few months as the central bank comes to grips with the reality of rising inflation.

This is despite, to the surprise of markets, holding rates at 0.1%, as inflation is expected to rise to 4.5% by the end of 2021, and 5% early next year.

Rather than suggesting the lack of action on rates was down to hesitancy, Andrew Bailey has said the bank is waiting on clarity around the conclusion of the furlough scheme and unemployment.

“We expect interest rates to rise and we are very clear,” Bailey said. “If you ask the question why haven’t you done it now? the answer is all to do with the labour market … there were a lot more people using the furlough scheme right up to the end.”

“The labour market looks tight in this country at the moment but the missing piece of evidence is just what has happened after the end of the furlough scheme and we don’t have any data to guide us on that,” he added.

However, labour constraints are only one side of the argument. An interest rate rise could have served to cool demand for goods, and thereby inflation.

The Bank of England, and other central banks for that matter, have in the past obsessed over achieving 2% inflation. With that number expected to soar to 5%, then surely at least a minimal rise in rates would be in order.

Of course, a key concern is the impact on mortgage rates and house prices.

Bailey said he was “very sorry” that UK inflation is rising and expected to go further, adding that “putting interest rates up, I'm afraid, isn't going to get us more gas”.

Danny Blanchflower, a former member of the MPC who is now an economics professor at Dartmouth College in America, said Bailey’s comments must be taken with a pinch of salt.

"We have no historical precedent for what's happened," he said. "We've never seen a shock of this kind and the big thing we are seeing at the moment is the furlough scheme is coming off, there is going to be an increase in taxes on National Insurance [and] universal credit was just cut.”

"So, the central bank really hasn't a lot of clue what is going on."

Blanchflower said: "This is a really big uncertain world and everybody should tread cautiously. I'm afraid I have to say... you have to take what the governor of the Bank of England and the Monetary Policy Committee said with a very large pinch of salt."

Finally, what does this all mean for the pound?

Cable, or GBP/USD, is expected to strengthen in the next year and could climb to $1.42 in the second half of 2022.

“The GBP is second best to the USD this year within the Major FX space. Supportive factors include hawkish cues from the BOE, COVID-19 hospitalization staying low despite a full reopening and attractive currency valuations,” according to the Quarterly Global Outlook from UOB Group’s Global Economics & Markets Research.

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