Bank Of England

Something odd is happening – the UK, and US economy and central banks in both economies are confusing the markets.

This week the US Federal Reserve and Bank of England have made noises. The noise emanating from the US was expected – like a few bars from a well-known symphony. By contrast the Bank of England was more akin to an out of tune violin, wailing – when the audience were expecting something much softer.

This week also saw news on UK and US inflation. UK inflation jumped up to 2.9 per cent, and more worryingly still, core inflation – with food, energy and tobacco stripped out – rose to 2.6 per cent. By contrast in the US, inflation fell to 1.9 per cent, core inflation was down to just 1.7 per cent, a two year low.

When central banks set interest rates, they are supposed to factor in inflation and inflation expectations. In the US, it seems to be on the wane, in the UK, on the up. Yet it’s the Fed that has been increasing interest rates – in the parlance of the markets, it’s the Fed that has been hawkish. It happened again this week, US interest rates were increased and for the second time this year. This takes the total number of hikes in US rates since the last few weeks of 2015 to four. US interest rates are now at 1.25 per cent.

In the UK, rates have been on hold ever since the rate cut a few weeks after the EU referendum last year. UK interest rates are at 0.25 per cent.

At first glance then, that is odd – US inflation is lower than in the UK, expectations for US inflation are modest, in the UK, it is expected to rise further. So, actually, you would expect the gap between US and UK rates to be much lower – if anything UK rates should be higher than in the US.

Yesterday, the Bank of England’s rate setting committee, the MPC, met and of the nine members, three voted for an increase in interest rates.

Looking at the inflation figures you might think that if anything, the MPC was not being hawkish enough.

It is just that the Fed hike was expected and indeed forecasters have been pencilling it in for some time. The MPC decision was wholly unexpected – markets thought that there may have been one vote for a rate hike, as there was in the past few meetings, but that was all.

The markets expected US rates to rise, but were coming around to the view that a hike in the UK rate was a long way off. The three votes favouring an increase came as a shock.

But, given the inflation numbers, you might think that the only surprise is that the markets were surprised.

It is just that the UK economy is going through a difficult stage. Data out yesterday revealed yet another fall in UK retail sales, they have fallen in four of the first five months of the year. And while the cost of living rises, average wages see their growth slow quite sharply – real wages are falling, and may be set to fall quite sharply.

And that takes us to a dilemma faced by the Bank of England.

Inflation figures suggest that higher interest rates might be called for, other data suggests that this is the last thing the UK economy needs.

If the Bank of England does conclude that, despite the economic winds blowing the UK’s way, interest rates need to go up anyway, then that will be a blow – a nasty blow to the UK.

But there are two reasons why interest rates may not be going up.

Reason number one, we have been here before. During the post 2008 period, inflation was much higher, but rates stayed at what was then a record low. Reason number two, Kristin Forbes, the MPC member who has been consistently voting for higher interest rates for some time, steps down from the MPC at the end of this month.