Will the Bank of England push rates up with war set to drag spending power down?

Soaring gas and electricity prices, high inflation, the worst squeeze for living standards in decades … The economic outlook was challenging even before Russia’s invasion of Ukraine.

Now conflict on European soil and economic warfare through sanctions has added to the pressure.

This week the Bank of England is expected to raise interest rates in response to inflationary pressures, as the war pushes up already high energy prices. It will be adding to the cost-of-living crisis by increasing the cost of borrowing, but the idea is to stop high rates of inflation becoming more permanent.

Threadneedle Street’s nine-member monetary policy committee (MPC) is likely to vote for a rise from 0.5% to 0.75%, lifting borrowing costs back to pre-pandemic levels for the first time. Some of its more hawkish members may push for a bigger rise, to 1%, which would be the highest rate since the 2008 financial crisis.

While all of this was likely before the first Russian tank rolled into Ukraine, Vladimir Putin’s war has complicated an already delicate balancing act for the central bank.

With the impact of western sanctions and Russian countermeasures driving up the cost of oil and gas on international markets, inflation is now set to peak at higher than the 7.25% forecast by the Bank for April, and stay at elevated levels for longer than first thought.

Raising borrowing costs has little impact on global energy prices, and such powerful headwinds will take steam out of the UK economy anyway

Some economists have spoken of inflation peaking close to 10%, compounding an already bitter cost-of-living crisis by adding to energy bills and driving up the cost of petrol and diesel to record levels.

Until Putin’s invasion, Britain’s economy was holding up better than had been expected. Official figures show gross domestic product (GDP) rose at a faster rate in January than City economists had forecast, with a 0.8% rebound on the month from the Omicron-driven dip in activity seen at the end of 2021.

Employment has continued to rise despite the end of the furlough scheme, and companies are still warning of shortages of workers and materials despite some signs of supply chain problems caused by Covid gradually fading.

However, it’s probable that growth in the opening months of the year was as good as it will get for some time, given the impact of the war on wholesale energy prices and supply lines. With households facing a harsher squeeze, consumer spending is expected to suffer, which will be a drag on economic growth.

Analysts at Goldman Sachs anticipate growth of about 1.2% in the first quarter of 2022, similar to the summer of last year, when the easing of pandemic restrictions helped repair some of the damage caused by Covid. However, GDP in the second quarter is expected to come in at only 0.4%.

According to analysts at UBS, every 10% increase in the price of fuel, electricity and gas has the effect of cutting about 0.3 percentage points from household spending and 0.2 percentage points from GDP growth. Some economists warn that a worst-case scenario of soaring oil prices and energy bills could even tip the UK economy into recession later this year.

Several people have therefore been asking whether the Bank should plough ahead with rate rises when the economy is slowing. Raising borrowing costs has little impact on global energy prices, and such powerful headwinds will take some of the steam out of the UK economy without the need for higher rates.

Economists believe Threadneedle Street will continue to prioritise keeping a lid on inflation over providing more support to the economy. However, with households facing the worst squeeze in incomes since at least the 1970s, it will need to tread very carefully.

Source: The Guardian