Has the Bank of England misjudged? Latest research warns: UK interest rates are not at "restrictive" levels at all, and Thursday's rate hike will be the start of calibration.

A new study shows that UK interest rates are restraining inflation less than the Bank of England previously judged, a conclusion that strengthens the case for a rate hike this week. Bank of England officials have argued that monetary policy is already in restrictive territory as the Iran conflict pushes up energy prices. However, an analysis found that current interest rates are likely close to neutral levels, meaning monetary policy is neither pushing inflation down nor pushing it up. The research suggests the Bank of England needs to act. Economists warn that inflation growth may breach 4% in early next yeartwice the central bank's target level. The market widely expects the Monetary Policy Committee to raise the benchmark rate by 25 basis points to 4% on Thursday, which would be the first rate hike in more than three years, but uncertainty remains over the magnitude of subsequent increases. "Judging by the trajectory of the economy, especially its performance in recent quarters, the Bank of England's policy stance has barely restrained aggregate demand spending," said economists Simon Lloyd and Dan Hanson. "Combined with the current inflation environment, this calls for a recalibration of policy, and the means is a rate hike. We expect the first hike to land on Thursday, with another to follow in February next year." Concerns that interest rates may not be high enough have intensified after a series of data showed the UK economy remained resilient in the face of the energy shock. August GDP unexpectedly grew for a third consecutive month, making the Bank of England's September forecast of 0.4% growth for the third quarter look overly pessimistic. The labor market also appears to be stabilizing. Several Monetary Policy Committee members who voted in September to keep rates at 3.75% argued that restrictive policy was helping contain inflation risks. But the economy's resilience has called into question their judgment that "slack is continuing to expand and policy is suppressing demand." "Our assessment is that the UK economy is closer to its inflation-free growth ceiling, which confirms that the central bank's current policy has a broadly neutral impact on aggregate spending," Lloyd and Hanson said. The key to this judgment is the output gap, the difference between actual GDP and the economy's potential capacity. Rising demand would mean slack is being used up; stronger supply would mean the gap remains stable or widens, which is a more favorable scenario for inflation. "The Bank of England appears to have taken the latter view," Lloyd and Hanson said. "Even as GDP continues to beat expectations, the central bank continues to argue that slack in the economy has been expanding." Modeled according to the Bank of England's measure of the output gap, interest rates appear to have a tightening effect. "By contrast, our estimate of the level of excess demand has been relatively stable. Since the fourth quarter of 2023, the indicator has fluctuated only within a range of a few tenths of a percentage point, standing at -0.2% of potential output at the end of the second quarter of 2026," Lloyd and Hanson said.