Interest rates could rise above 2% in the coming year as the Bank of England acts to prevent high inflation becoming embedded in the economy, one of its policy setters has said.
Michael Saunders, who leaves Threadneedle Street’s monetary policy committee (MPC) next month, said he supported tighter policy because the risks of doing “too little, too late” outweighed the risks of doing “too much, too soon”.
In a valedictory speech to the Resolution Foundation thinktank, Saunders said further increases in official borrowing costs were needed even though the economy had slowed in recent months.
Polls of economists and the view taken by the financial markets suggested UK interest rates were on course to rise from their current level of 1.25% to 2% or even higher in the coming year, Saunders said.
“I do not regard such an outcome as implausible or unlikely,” he added.
Saunders was one of three members of the Bank’s nine-strong MPC who voted for a half-point increase when interest rates were raised from 1% to 1.25% last month.
With the annual inflation rate expected to edge closer to 10% when the latest cost of living figures are released later this week, a further increase in interest rates is expected at the MPC’s August meeting.
Saunders said a series of negative shocks – including Brexit, the Covid-19 pandemic and spiralling energy prices – had reduced the rate at which the economy could grow without generating higher inflation.
“The deterioration in potential output over recent years means that capacity pressures are widespread even with GDP only slightly above the pre-pandemic level,” he said.
There were signs economic activity was slowing, as rising prices eroded living standards, the MPC member added. “But this slowdown must be gauged against the backdrop that the economy early this year was in excess demand, potential growth is low, recruitment difficulties are elevated, and there is a sizeable backlog of unmet labour demand,” he said.
“Moreover, since the May monetary policy report forecast, the government has announced further fiscal support measures.”
Saunders said his view was that a further ratcheting-up of interest rates was likely, and signalled he would again be voting for a half-point increase next month.
“In broad terms, the MPC has to balance the risks and costs of tightening ‘too much, too soon’ versus ‘too little, too late’. In my view, the cost of the second outcome – not tightening promptly enough – would be relatively high at present.
“With excess demand and elevated inflation, ‘too little, too late’ would increase the likelihood that recent trends in underlying pay growth, longer-term inflation expectations and firms’ pricing strategies become more firmly embedded,” Saunders said.