The BoE’s decision to implement back-to-back rate hikes, for the first time since 2004, heaps yet more pressure on stretched household finances and struggling businesses.

The Bank of England yesterday (Thursday, Feb 3) raised interest rates for the UK economy from 0.25% to 0.5%, its highest level since the early days of the virus crisis, after already raising them 15 basis points in December. The BOE also voted to begin quantitative tightening (QT) by paring back its holdings of government bonds. This it will do by allowing maturing government bonds to expire without replacing them, and by selling its corporate bonds outright.

Following its decision to hike rates, the BoE warned of a record slump in living standards, although obviously some people (ie, those in the lower and middle classes whose finances are already stretched to the limit) will be more affected than others (eg the super rich, who have so far done exceedingly well out of the virus crisis).

The decision by the bank’s Monetary Policy Committee to hike rates was passed by a majority of five to four. Interestingly, the minority wanted an even larger increase to 0.75%, underscoring the Monetary Policy Committee’s increasingly hawkish stance. It was the UK’s first back- to-back interest rate hike since 2004.

Asked why the BoE is heaping yet more pressure on struggling households, the bank’s governor, Andrew Bailey, said: “If we don’t take this action it will be even worse. It’s a hard message. I know it’s a hard message.”

The BoE forecast that inflation could rise as high as 7.5% by April. It is currently at 5.4%, its highest level in 30 years. The huge monetary stimulus programs unleashed by the world’s largest central banks in the first months of the virus crisis and maintained for over a year and a half, are almost certainly exacerbating global price rises, especially as this huge expansion of money supply has coincided with a sharply limited supply of vital products.

However, as Yves pointed out a couple of days ago in her preamble to the cross-post“Inflation Paranoia Threatens Recovery“, the effects of the rate hikes on inflation are likely to be muted given that many of the factors driving inflation are far beyond the scope of central bank control. Those factors include high energy and commodity prices; extreme weather events that have led to poor harvests; and Covid-short-staffing-related supply chain issues. Those issues are now being exacerbated by the vaccine mandates being imposed by some governments on key logistics workers such as truckers and port workers.

The central banks of large emerging market economies such as Brazil and Mexico have already tried to bring inflation under control through successive interest rate hikes. All they have achieved so far is to bring an abrupt end to their respective economies’ lackluster post-lockdown recovery. Both are now in technical recession. Meanwhile, the latest data (from December in the case of Brazil and January in the case of Mexico) show that inflation in each country remains little changed, clocking in respectively at 10.06% (down from 10.74% in November) and 7.36% in Mexico (down from 7.37% in December).

The interest rate hikes are squeezing yet more life out of the economy by making it even harder for heavily indebted businesses and consumers to service their debts. The result could be a stagflationary spiral, as already appears to be happening in Brazil. As Bloomberg reported in December, the dreaded combo of surging prices and stagnating economic activity is hitting the poorest Brazilians the hardest.

But emerging market central banks have less choice in the matter of whether or not to hike rates than their advanced economy counterparts. Besides trying to bring inflation under control, central banks in these countries also have to defend their currencies against a strengthening dollar, as I noted in my December 10 article, “Inflation Continues to Soar in Latin America, Even As Central Banks Intensify Their Rate Hikes“:

They know that if financial conditions in the US and other advanced economies were to suddenly tighten, as the Fed and other major central banks begin hiking rates to stifle inflation (which isn’t beyond the realms of possibility), it could spark sharp asset sell offs and capital outflows in their own economies. And that is how many financial crises in Latin American have begun.

Back in the UK, markets now expect the BoE to raise interest rates to at least 1% by May, and 1.5% by November — a level that was not expected to be reached until March 2023 prior to Thursday’s announcement. Rising borrowing costs are likely to cause crippling economic pain for struggling consumers and businesses, especially with inflation already at a 30-year high of 5.4% and expected to continue to rise, at least in the short to medium term.

Rising prices of many essential goods and services are already biting hard into general living standards. Data published by the Office for National Statistics (ONS) on January 18 showed that average earnings climbed 3.5% year over year in November, 0.9 percentage points below the rate of increase for consumer prices. It was the first registered fall in real incomes since July 2020. Conditions are set to get even worse in April when increases in utility bills and taxes kick in.

It is against this backdrop that the BoE has decided to hike rates, as the FT reports:

The rise in official interest rates, alongside the highest rate of inflation for more than 30 years, would squeeze disposable household incomes by 2 per cent this year, with a further 0.5 per cent hit in 2023. That would be the biggest annual reduction in spending power since at least 1990, said BoE officials.

This would depress spending and reduce the UK growth rate to a crawl of about 1 per cent a year. However, the pain for households would help bring inflation down towards the bank’s 2 per cent target within two years, the MPC said.

The pain will not just be limited to heavily indebted households, which are once again ramping up their credit card debt. Many of the small and medium sized businesses that had to take on huge amounts of debt, in many cases for the first time ever, just to weather the lockdowns of 2020 will also feel the pinch (or in this case, the punch).

In October 2021, the Bank of England reported that a third of the UK’s small businesses are classed as highly indebted, more than double since before the Covid-19 pandemic. Thirty-three percent of SMEs saw their debt levels rise to more than 10 times their cash balances, compared to 14% before the pandemic. The proportion of those with high debt relative to both cash balances and monthly inflows surged to 10% from 3% during the same period.

“Although debt appears affordable in the near term, insolvencies are likely to rise from 2021 Q4 as government support is withdrawn as planned,” the BoE’s Financial Policy Committee saidadding that rising arrears did not represent a “significant risk” to the UK’s banking sector.

The main reason for this is that most of the risk has been borne by public finances. The UK government has guaranteed 100% of the funds disbursed by banks as part of the Bounce Back Loan Scheme (BBLS), which was aimed at SMEs, micro businesses and other businesses requiring small loans of between £2,000 and £50,000. It has also underwritten 80% of the funds disbursed by banks in the other three emergency business loan programs, the Coronavirus business interruption loan scheme (CBILS), the Coronavirus larger business interruption loan scheme (CLBILS) and the Recovery Loan Scheme.

In total, the Government has provided over £200 billion of emergency loans, guarantees and insurance cover to private sector firms since the pandemic began. In other words, as a UK parliamentary report warned in December, “if borrowers default, there will be a direct cost to the Government.”