The Bank of England kept policy on hold at today's meeting, as widely expected. It has nudged up its Q3 GDP expectation, yet, by warning that Brexit uncertainty has increased even since August, the MPC could stay put on rates in the near future, as Brexit negotiations approach a crucial stage - including a soft deadline for a withdrawal deal in mid-November. Yet, the Bank has maintained a mild tightening bias, suggesting that a “gradual and limited” hiking cycle is appropriate under most circumstances going forward. Having increased rates at its August meeting, the Bank is likely to hike once again over the next year, provided Brexit negotiations proceed smoothly.
Justifying higher rates has been a sober take on the supply side of the economy: in a context of sluggish potential growth, the limited spare capacity left in the economy is quickly disappearing, and excess demand is building. In order to avoid a last minute overreaction to inflationary pressures likely to emerge down the road, and taking into account the fact that monetary policy works with a lag, the Bank look still to be eyeing around three rate hikes in the next three years. That would take the Bank rate up to their estimate of short-term equilibrium, currently seen between 1.5% and 2%. This equilibrium rate (r*), defined as that needed to keep the economy on an even keel, is expected to rise to 2-3% thereafter. The logic being that faster productivity growth spurs wages, and leveraging continues to pick-up.
However, in light of domestic and external risks, the Bank is likely to end up under-delivering, falling short of its ‘Goldilocks’ rate. Crucially, gradual and limited tightening is conditional on a relatively smooth Brexit transition, an assumption that could unravel, should negotiations turn sour. Going forward, the Bank will continue to focus squarely on how Brexit negotiations evolve and whether the economy performs in line with their cautiously positive forecasts through the process.