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The deputy governor of the Bank of England has warned that financial markets have underestimated the chance of further interest rate rises.
In a speech at the London School of Economics on Wednesday, Ben Broadbent said markets had placed too much emphasis on the idea that interest rates needed to be kept low in the face of Brexit uncertainty.
The deputy governor said it was “uncertain” and “complex” to anticipate how Brexit would affect inflation. But he rejected the assertion that Brexit “necessarily implies low interest rates”.
“Even as inflation rose, and the rate of unemployment fell further, interest-rate markets continued to under-weight the possibility that [the] bank rate might actually go up this year,” he said.
The BoE’s Monetary Policy Committee announced its first interest rate rise in more than a decade earlier this month. But the central bank has struggled to convince financial markets that it is likely to raise rates further.
BoE officials were taken aback when sterling sold off on the day it announced the rate rise, and two-year gilt yields remain below the BoE base rate, suggesting markets are sceptical that the MPC will raise rates further while there is still considerable uncertainty around the UK’s economic future outside of the EU.
Brexit-related uncertainty could weigh on demand and motivate the MPC to keep interest rates low to support the economy, but other factors could push the central bank to raise rates. For example, if Brexit reduced the UK’s openness to trade, the country’s output capacity could suffer, which would require the BoE to raise rates to temper inflation.
“Economists often presume that changes in an economy’s underlying productivity occur only slowly,” Mr Broadbent said. However, he added: “A sharp reduction in the degree of openness [to trade] could have a more immediate impact.
“A field currently producing barley, sold into the European market, can’t easily or as fruitfully be replanted with olive trees.”
He said the challenge for monetary policymakers was that “reductions in supply can add inflationary pressure even as they lower aggregate [gross domestic product]”.