Bank of England plays a clever game on rates

In the post-crash world, central bankers prefer to telegraph interest rate changes, sometimes months in advance so as to avoid whipping up greater market volatility.

The downside of this new system of “forward guidance”, for currency analysts, has been a virtual scrambling to make sense of the comments that accompany rate announcements: whether they are more or less hawkish than last time; or whether the emphasis on a certain issue has changed.

The Bank of England cleverly exploited this yesterday. While keeping UK rates at an historic low of 0.25 per cent but sounding more hawkisk on the possibility of a future rate hike, it managed to simultaneously support sterling while deferring more decisive action to cool inflation, now running at 2.9 per cent, until the Brexit landscape becomes clearer.

As expected, the bank’s nine-strong monetary policy committee voted 7-2 to keep interest rates on hold. However, the bank said policymakers believed “some withdrawal of monetary stimulus was likely to be appropriate over the coming months” – its strongest signal of a rate hike yet.

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Within minutes, sterling had surged 1.5 per cent against the euro to be trading at 88p, its highest level in months, providing some relief for Irish exporters, who have been in the eye of the Brexit storm.

Bullish fervour

In a TV interview later governor Mark Carney added to the bullish fervour, suggesting the possibility of a rate increase had definitely increased.

The bank and Carney have previously signalled the probability of rate hikes ahead, only to be caught out by unexpected changes in the economy, and yesterday’s decision doesn’t change the difficult position it finds itself in.

With UK unemployment at a 40-year low of 4.3 per cent and inflation ticking up towards 3 per cent, conventional economic wisdom calls for a rate hike to cool the economy and halt inflation.

However, Britain is also being swept along by two unusual rip tides, one peculiar to the UK and the other global.

The peculiar current is Brexit. If the bank ups rates and stymies consumption and investment before the full economic impact of the UK’s EU exit materialises, it risks compounding the likely fall-off in economic growth.

Wage growth

The other more global current relates to wage growth. Normally when economies tend towards full employment, wages begin to rise as employers chase a shrinking pool of labour.

However, wage growth in the UK, the US and Ireland, where job creation rates have been strong, remains unusually sluggish, confounding the traditional economic paradigm.

Average wages in the UK are rising at an annual pace of 2.1 per cent, but with inflation at 2.9 per cent, that means real wages are actually falling, another reason for the Bank of England to be wary of raising rates.

The fear is that if the gap between inflation and wage growth gets too wide, consumer spending – the engine of the economy, which has been relatively robust to this point – will begin to slow, stalling economic growth further.

Nobody seems to have a handle on why incomes have been slow to rise. It may be that the new jobs are poorly paid; or that young people are commanding less income. Perhaps firms are still nervy about lifting wages. Another theory is that there is significant underemployment in the new gig economy.

Either way, the Bank of England finds itself on horns of a dilemma over interest rates.