Bank of England signals interest rates probably won’t go much higher

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Interest rates have risen to their highest level in more than a decade but probably won’t go much higher than 3%. That was the message from the Bank of England as it sought to soften the blow from the sharpest rise in the cost of borrowing in more than three decades.

Threadneedle Street’s forecasts for the economy look grim. Output has already started to contract and will go on falling for the next two years – the longest recession of modern times. Unemployment will almost double, with the jobless rate rising from 3.5% to almost 6.5%. Inflation will fall from 10.1% to well below its 2% target over the next two years.

Crucially, though, the forecasts in the Bank’s quarterly monetary policy report assume that interest rates rise to the levels expected by the financial markets. At the end of October, when the report was being prepared, a peak of 5.25% was envisaged, but it has since fallen back to 4.75%.

The Bank clearly doesn’t see rates going that high. According to the minutes of its latest meeting the majority of its nine-strong monetary policy committee (MPC) believes “further increases in bank rate may be required for a sustainable return of inflation to target, albeit to a peak lower than priced in to financial markets”.

The reason Threadneedle Street felt the need to massage down interest rate expectations is obvious.

If the Bank were to hold rates constant at 3%, inflation would come down a bit more slowly, but would still be more than a percentage point below its target in three years’ time. And while the damage to the economy would be less severe, it would still be considerable. The peak to trough fall in gross domestic product would be 1.7% rather than 2.9% and unemployment would rise to just over 5% rather than 6.5%.

Already, some members of the MPC are getting nervous about squeezing a fragile economy too hard. Only seven of the nine voted for a 0.75-point increase, with Swati Dhingra opting for a half-point rise and Silvana Tenreyro going for a quarter-point hike.

The MPC has now raised interest rates at its last eight meetings, during which time the official cost of borrowing has risen from 0.1% to a level last seen in late 2008. Tenreyro said the economy was already in recession and that most of the tightening of policy over the past year had yet to feed through to the real economy.

The majority of the MPC remained concerned about the tightness of the labour market, although its own forecasts suggest it won’t stay tight for much longer. It has not factored into its forecasts the higher taxes and cuts to public spending due to be announced by Jeremy Hunt on 17 November, even though the chancellor’s autumn statement will slow the economy still further.

Financial markets will view the MPC as markedly more dove-ish than they were anticipating. The Bank is suggesting a further tweak to interest rates will be needed but that anything more would be overkill.