The Bank of England has signalled that its move to raise interest rates for the first time in a decade could quickly be reversed if the stalled Brexit negotiations fall apart.
On Thursday the bank's monetary policy committee (MPC) voted by a margin of 7-2 to raise its key lending rate to 0.5 per cent from 0.25 per cent. It was the first rate increases time since July 2007, and most investors and economists believe more hikes are coming over the next couple of years. However, Bank of England Governor Mark Carney hinted strongly that the increase could be a one-off. It all depended, he said, on how Britain's negotiations with the European Union proceed and how businesses and consumers react to the final outcome.
For now, those discussions are not going well. When British Prime Minister Theresa May triggered the EU's exit mechanism last March, she hoped negotiations would move quickly toward the finalization of a U.K.-EU free trade agreement, along the lines of the Canada-EU trade deal. That hasn't happened, and instead, the negotiations have bogged down over a host of issues, notably how much Britain should pay to settle its EU financial obligations.
And time is running out. Britain formally leaves the EU in March 2019, with or without an agreement. Ms. May has proposed a transition period of around two years to give businesses time to adjust to whatever the outcome, but even that has yet to be agreed to.
Her leadership has also come into question ever since she called an election in June that saw her Conservatives lose seats in Parliament, forcing her to form a minority government reliant on support from a small party based in Northern Ireland. Ms. May faced another blow on Wednesday when long-time cabinet minister Michael Fallon resigned as Defence Minister over allegations of sexual harassment.
Mr. Carney said that progress or failure on the transition arrangement and the final Brexit deal will have a major impact on the U.K. economy and could force the MPC to raise or lower interest rates.
"These aren't normal times," he said. "What matters to us is what people think is going to happen and how they react to it. A little more progress or little less progress will matter for the economy to the extent to which people change their attitudes and change their spending plans both positively and negatively." Once there is some clarity "we as a committee will have to step back and assess the new outlook and calibrate policy appropriately."
Mr. Carney added that almost half of the U.K.'s businesses are affected by Brexit. "Those businesses, in general, are anticipating an agreement…They are anticipating some form of transition," he said. The MPC also said in a statement that "the decision to leave the European Union is having a noticeable impact on the economic outlook."
The governor and other bank officials haven't been shy in warning about the risks of Brexit. During the referendum campaign, Mr. Carney faced criticism for issuing gloomy predictions about leaving the EU. This week, a bank official told a parliamentary committee that 10,000 financial services jobs could be lost on the first day of Brexit if there was no trade deal and that up to 75,000 positions could be cut in the longer term. That led one committee member, Conservative MP Jacob Rees-Mogg, to reply: "Sadly, the Bank of England is no longer taken seriously as it has called wolf too many times."
Mr. Carney said the main reason for a rate hike now was largely because inflation has gone well above the bank's 2 per cent target. Inflation hit a five-year high of 3 per cent in September, and the bank believes it will be slightly higher in October. Much of that inflation has been driven by the lower value of sterling, which fell sharply after the EU referendum in June 2016, causing import prices to rise.
Mr. Carney said that with unemployment down to 4.3 per cent and the economy growing slowly, "the time has come to ease our foot a little off the accelerator … Any future increases in bank rate would be at a gradual pace and to a limited extent." Financial markets are expecting two more rate hikes over the next couple of years, taking the rate to 1 per cent by 2020.
The bank also revised its forecast for economic growth in 2017, increasing it to 1.5 per cent from 1.3 per cent. It lowered its forecast for 2018 to 1.7 per cent from 1.8 per cent, and left its 2019 outlook unchanged at 1.7 per cent. Unemployment is expected to remain at 4.2 per cent through to 2019.
"This was about as dovish a hike as you get," said Neil Wilson, senior market analyst at ETX Capital. "From the cautious language, it's more like one and wait-and-see. Further hikes will be 'at a gradual pace and to a limited extent'. With Brexit weighing on the outlook, this could just as easily be reversed next year."
Sam Hill, senior U.K. economist at RBC Capital Markets in London, also called the increase "a dovish hike" and said the chances of a further increase in the next 14 months is low. "Although the formal assumptions on Brexit didn't change – the 'smooth transition' is still part of the forecasts – there was again an acknowledgement of the 'considerable risks to the outlook' where EU exit is concerned," he said. "Our forecast remains that there won't be a further hike in 2018."