Will interest rates rise faster than we think?

The weak pound and price of oil could force Mark Carney’s hand

“Bank of England Governor Mark Carney and his colleagues on the Monetary Policy Committee will not welcome this week’s latest bout of weakness in sterling or renewed strength in the oil price, as both are complicating factors when it comes to inflation, which at 3% is still running some away above the official 2% target,” says AJ Bell Investment Director Russ Mould.

“It does seem that a sustained drop in the value of the pound can lead to inflation, while strength can help dampen it down (see chart 1 below). The Bank might be able to do something about this, by raising interest rates more quickly than the markets currently anticipate to make sterling a more attractive proposition relative to say the dollar, yen, or euro. A 12-month LIBOR rate of 0.77% suggests that investors are currently factoring in just one more quarter-point borrowing cost hike by this time next year.

“Whether the MPC wants to quickly tighten policy remains to be seen, given lingering doubts over the UK’s economic momentum and the Bank of England’s widely-voiced concerns about the possible impact of Brexit come 2019.

“The Bank may be more concerned about oil prices. Movements in Brent crude also seem to have a big say in the rate of inflation in the UK (see chart 2 below). The MPC has no influence over this at all – Riyadh, Moscow, Texas and Tehran are the key power brokers here, not Threadneedle Street, London.

“The Bank will be hoping that oil starts to run out of puff at around $60 a barrel – if it does, then the latest rally in crude will begin to drop out of the calculations in 12 months’ time and the MPC will feel more comfortable in taking the view that the spike in UK consumer price inflation to 3% will be relatively temporary.

“If the price of oil continues to climb the Bank of England, it could find itself having to tighten monetary policy more than it would like to ahead of the Brexit deadline of March 2019 to nip any inflationary (or stagflationary) fears in the bud.”

Chart 1 – UK CPI vs Sterling

Source: Bank of England, Office for National Statistics

Chart 2 – UK CPI vs Oil

Source: Thomson Reuters Datastream, Office for National Statistics

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