The Bank of England is moving from an era of near-zero interest rates, which have been below the rate of inflation since 2009, to a new normal of rates eventually being back above inflation. While inflation looks set to fall to 2% by early 2024, unwinding quantitative easing will take much longer.
The Bank of England’s monetary policy is currently in transition. For over a decade, the Bank kept its policy rate at near zero (making it very cheap for banks and other financial institutions to borrow) and managed to keep longer-term interest rates low by buying government debt (a process known as quantitative easing or QE). Interest rates were also below the rate of inflation for most of this period – or in more technical language, the ‘real interest rate’ (the market or policy rate minus inflation) was negative (see Figures 1,2,3).
Figure 1: Consumer price inflation (CPI), 2013-2023
Source: Office for National Statistics (ONS)
Figure 2: Bank rate, 1975-2023
Source: Bank of England
Figure 3: Real rate, 2020-2022
Source: ONS, Bank of England
All of these elements were exceptional by historic standards: prior to 2009, policy rates were never so close to zero; policy rates were almost always above the rate of inflation (with a few brief exceptions such as occurred in the 1970s); and QE had not been practised on anything like the recent scale.
But with rising inflation in late 2021, the Bank has been forced to raise interest rates and to start reversing QE (with the process of quantitative tightening, or QT). This change in policy was not only driven by domestic considerations, but also the need to follow a similar shift by the US Federal Reserve and other central banks. The Bank of England has raised its policy rate from 0.5% in February 2022 to its current level of 4% announced on 2 February 2023.
This transition is not easy. While the current level of interest rates is low by historical standards and significantly below the rate of inflation, for households, businesses and financial markets used to near-zero rates for over a decade, today’s rates seem high.
The rise in interest rates is also taking place against a backdrop of difficult economic conditions in the UK. This takes the form of low post-pandemic growth and the continued negative effects of Brexit, with the economic misery exacerbated by the impact of food and energy price inflation at the heart of the cost of living crisis (which is having a particularly harmful effect on lower-income households).
That being said, the economic outlook has actually improved since the Bank’s previous quarterly Monetary Policy Report in November 2022. In the absence of further adverse geopolitical developments, it is now clear that inflation peaked at 11.1% in October 2022 and is set to decline rapidly in 2023.
The Bank’s Monetary Policy Report of February 2023 sees the rate of inflation returning to 2% by early 2024. The inflationary outlook has been helped by the rapid fall in natural gas forward prices since mid-2022: from a peak of £593 per therm in August to its current value of £214 (see Figure 4). Likewise, oil and petrol prices have fallen significantly. This has turned out to be much ‘less worse’ than feared in mid-2022, when some economists projected energy prices remaining persistently high into 2023.
Figure 4: Natural gas prices, forward delivery contracts, 2022-2023
The prospects for growth remain low, but they have improved slightly. UK output is still projected to fall slightly in 2023, but by less than previously predicted. The labour market remains tight, with a slow rise in unemployment projected from its current historically low level of 3.8% to 5% by 2025. The Bank has noted that the supply of labour remains low due to a fall in the participation rates of older workers, many of whom left employment during the pandemic.
While there is a danger of wage inflation persisting and feeding through into general inflation, the Bank also believes that labour market conditions will loosen and that wage inflation will fall from its current level of around 7% later in 2023. While wage inflation is causing price increases in the services sector, it has yet to develop into a wage-price spiral. The Bank highlights wage inflation as something to watch, but its central forecast does not see it as a problem.
The latest Monetary Policy Report discusses the effect of the Bank’s interest rate policy on the economy. House prices are expected to fall in 2023 (although the Bank does not say by how much). Mortgage rates have increased substantially to around 6% and ‘mortgage approvals declined sharply in November and December to levels not seen since the onset of the pandemic’. Likewise, interest rates for lending to firms have increased. Higher energy prices and mortgage interest payments are both causing individual households to consume less.
So, why did the Monetary Policy Committee (MPC) think that an increase of 0.5 percentage points in the interest rate was required given that inflation is expected to fall back to target over the next 12 months and output is expected to fall? The decision was split, with two out of seven committee members voting for no increase. The justification is given in terms of risk management.
‘The risks to the inflation outlook in the medium term were both large and asymmetric, with a skew towards greater persistence. This warranted additional weight being put on recent strength in the labour market and inflation data, and relatively less on the medium-term projections. A 0.5 percentage point increase in Bank Rate at this meeting would address the risk that domestic wage and price pressures remained elevated even as external cost pressures waned.’
In plain English, the committee is saying that there is still a lot of uncertainty, and most of the risks are for inflation to be higher than expected: raising interest rates covers us in case inflation remains stubbornly high.
One thing that is not discussed in the Bank’s February report is where the MPC sees interest rate policy going beyond 2023. Their forecasts are based on financial market expectations, which see interest rates rising slightly to 4.3% by early 2024 and then falling back to 3.3% by 2026.
These figures are highly significant. They imply that that by late 2023 and into 2024, we will see interest rates exceeding the inflation rate – that is, the real rate of interest becoming positive. Indeed, the Bank’s forecast of consumer price inflation (CPI) for 2024 onwards is that it will mostly be below the 2% target. A policy rate of 3% would imply a real interest rate of above 1% if inflation is below 2% (since the real rate is simply the policy rate minus the inflation rate).
This would indicate an end to a period of almost 14 years where real interest rates have been negative. From a historical perspective, the interest rate has almost always been above the inflation rate (the main exceptions including a few years in the 1970s) and the previous decade was an anomaly.
For economists, it is the real interest rate that determines the saving and investment decisions of households and firms, and hence GDP. The equilibrium real interest rate is usually seen as being positive, reflecting the fact that when you invest in capital you should (on average) get more out than you put in (for a recent estimate of the equilibrium real interest, see Kiley, 2020, who puts it slightly under 1% for the United States).
If the MPC decides to keep the policy rate above 3% in the future, this would imply that the Bank of England will have completed its transition by early 2024 from the policy of near-zero policy rates and negative real rates after the global financial crisis of 2007-09, back to the historical norm of positive real rates, with the policy rate exceeding the inflation rate.
The remaining task for the transition to be complete is the complete unwinding of QE. This is currently happening at a snail’s pace. The Bank’s QE offshoot – the Asset Purchase Facility – published its planned sales of assets as part of QT. In the latest schedule (Gilt Sales Notice 16/12/22), the asset sales represent little over 1% of QE assets to be sold over the first quarter of 2023. So, while interest rate policy may have gone ‘back to normal’ by 2024, the results of QE will be with us for much longer.
The Bank’s February report is more optimistic than it was in November, although the rise in interest rates by 0.5 percentage points was still seen as necessary because of continuing uncertainty. The transition back to more normal interest rates should be achieved by early 2024 as inflation drops below the policy rate. But it will take longer to unwind the legacy of QE.
Where can I find out more?
- The economic landscape: structural change, global R* and the missing-investment puzzle: speech by Andrew Bailey, Governor of the Bank of England in July 2022.
- What can the data tell us about the equilibrium real interest rate? Study by Michael Kiley in the International Journal of Central Banking 16: 181-209 (2020).
- Eight centuries of the real rate of interest 1311-2018: Bank of England Working Paper No. 845 by Paul Schmelzing.
Who are experts on this question?
- Kate Barker
- Jagjit Chadha
- Huw Dixon
- Stephen Millard
- Paul Tucker