It will be painful but the Bank has made the right decision on interest rates

On 3 November, the Bank of England Monetary Policy Committee voted to increase interest rates by a historically large three-quarters of a point this week, despite forecasting that the UK economy is sliding into recession. I understand this confusion, but there are three reasons why rates had to be increased.

First, the job of the Bank’s Monetary Policy Committee is to worry about inflation, not growth. Some might like to change the MPC’s mandate, but for now it is tasked with keeping inflation at 2 per cent. Inflation is now over 10 per cent and forecast to remain high. With inflation now having spread well beyond food and energy prices, the MPC needed toSecond, the starting point is important.

The international context is also important. Other major central banks, including the US Federal Reserve and the European Central Bank, have already raised their key rates by three-quarters of a point. The Bank of England needed to join this club in order to prevent renewed weakness in the pound, which would have added toThird, expectations are crucial. The Bank has a credibility problem after leaving interest rates too low for too long.

This applies to expectations for interest rates, too. The Bank’s gloomy forecasts for growth and unemployment are based on market expectations for the future path of interest rates, which point to a peak of around 5.25 per cent in 2023 Q3. This is probably too pessimistic, as some MPC members have already suggested.

However, if the Bank had raised rates by less than the three-quarter point that the markets were expecting this week, investors might have thought the MPC was going soft on inflation again, and priced in even bigger increases later as the MPC tries to catch up.. Relatively few mortgages are directly linked to the Bank of England’s policy rate. Instead they depend on where interest rates are expected to be over the life of the loan.

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