BoE raises interest rates to new 15-year high

London Business School’s Assistant Professor of Economics Vania Stavrakeva recently appeared on Bloomberg Radio’s The Tape Podcast, talking about the Bank of England’s decision to raise interest rate to 5.25 percent while also exploring the economic environment for the Eurozone and the US economy.

The Bank of England has signalled that interest rates could remain above five percent until 2026 in a move that will sharply raise costs for more than four million mortgage holders.

Policymakers voted 6-3 to raise interest rates by 0.25 percentage points to a 15-year high of 5.25 percent. Andrew Bailey, the Governor of the Bank of England, said it was vital that officials “make absolutely sure” that inflation fell “all the way back to the two percent target”.

Speaking on Bloomberg’s The Tape podcast, Dr Stavrakeva said there was an expectation for the Bank of England to hike interest rates given that core CPI figures are still very high at 6.9 percent. “It is somewhat embarrassing for the Bank of England to be essentially the central bank of an advanced economy with the highest CPI numbers. I don’t think they had a choice.”

With inflation coming down in the US what is driving inflation in the UK and why is it proving to be more stubborn than other parts of the world?

“The principal difference between the UK, and the US economy for example, is wage inflation,” said Dr Stavrakeva. “The UK is problematic because it got hit by Brexit at the same time as this period of high inflation. Brexit has limited the inflow of workers from the Eurozone, and the economy has also been hit by other structural problems such as the long-term sick who are unable to return to the labour market, a situation that is significantly higher than in other countries and is estimated to be as high as half a million people. Moreover, we’re seeing a lot more strikes in the UK which are the result of a long period of austerity and a prolonged fall in public sector wages”.

Dr Stavrakeva said that these trends were not to disappear when one considers public sector wage increases of six percent and with CPI sitting at seven percent. “I don’t think public sector workers are going to be satisfied with their wages and strike action is going to continue, which will further feed into wage inflation in the UK”.

How has inflation impacted other economies in Europe?

“The Eurozone is quite interesting because there is massive heterogeneity across countries within the European Community,” says Stavrakeva.
“This is the problem when you have a single central bank and many different business cycles. We know, for example, that in southern European countries the inflation rate is significantly lower than in Germany, and then you have Eastern Europe where inflation is still very high.”

“Historically, the ECB has tended to place an oversized weight on Germany which has proved to be both a political and economic problem,” observed Dr Stavrakeva. “When you are fighting inflation within the Eurozone, which economy are you going to target? One can see that the Eurozone is not really growing at the moment, at best it is flat. The outlook therefore is much gloomier for the Eurozone and there are some that think that the ECB has rather overdone rate hikes. Overall, it is going to be a bigger struggle for the Eurozone to achieve growth given the heterogeneity of business cycles.”

Investors are increasing betting that Europe will sink into a painful economic downturn, in growing contrast to the conviction in financial markets that the US is headed for a “soft landing”. But what of Europe’s overreliance on China?

European Commission President Ursula Von der Leyen has said the bloc will not decouple from China, but needed to reduce risk and "rebalance" economic ties.

“Demand hasn’t really recovered in China,” says Stavrakeva. “The forecasts for China are not particular optimistic, so this is putting a drag on exporting countries such as Germany and we’re seeing that growth in that country is definitely lower. Overall, I would be surprised if we don’t see at least mild recession in the Eurozone.”

Can the US be shielded against the impact of other economies, and still continue to grow?

“The US is a fairly closed economy,” says Stavrakeva. “It is linked principally through financial intermediation in the global financial markets, so the impacts of lower, or reduced trade is of a second order importance to the US.”

With regard to the so-called soft-landing for the US economy, Dr Stavrakeva says that she is of the opinion that the US is not yet “out of the woods” and that the soft landing narrative is somewhat surprising given that the economy still suffers from a core CPI of 4.8 percent.

“I am of the opinion that the US is going to find it harder to get it down to its target of two percent.”

Credit spreads currently appear too tight given rising rates and recession risks. “The problem is that markets are pricing in a soft landing narrative and the economy is doing better than expected and so the result is that we are seeing that spreads are tight and the difference between high yield corporate debt and the Treasury is narrowing despite the fact that interest rates are increasing. This is very surprising,” says Stavrakeva. “Risk appetite is growing particularly for US assets and that is making the job of the Fed harder.”

Stavrakeva observes that with credit risk increases we could see growth slowing in the US, “so that’s not a soft landing, that is going to be recessionary”.