(The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own)


LONDON - For all the noise about the Fed's hawkish twist this week, the Bank of England stole the show to became the first G7 central bank into the great post-pandemic interest rate rise experiment.

The problem is that no one's sure how it will pan out - not least because the pandemic is far from over and Britain is bearing the brunt of the latest wave, along with accompanying new social and travel restrictions.

Everyone's guessing here. Just how much has changed structurally in the world economy since COVID first hit And what, if anything, can any central bank do to curb the highest inflation rates in decades when the problem is a supply shock and rate rises only crimp demand via tighter credit

After befuddling financial markets for the second time in as many months, the BoE lifted its main policy rate on Thursday by 0.15 basis points to 0.25% - albeit still half a point below where it was before the pandemic hit in March last year.

Investors were slightly nonplussed - and lifted sterling, short gilt yields and bank stocks but flattened the benchmark bond yield curve signalling growth concerns ahead.

The irritation at the bank's signalling is understandable. Having suddenly talked up an imminent rate hike through October, the BoE blanched at its November meeting, followed through by publicly fretting about the impact of the new Omicron variant - only to surprise again by pulling the trigger this week when a majority of forecasters had dialed back.

Screwy guidance aside, political pressure to cap 5%-plus UK inflation rate that's more than twice the central bank's 2% target is clearly mounting as real household incomes get squeezed. The International Monetary Fund this week warned the BoE against submitting to "inaction bias" - or a tendency to wait and see.

Restrictions imposed to confront Omicron and the numbers of people off sick or isolating will inevitably squeeze the economy through the winter once again, but may also add to inflation pressures by exaggerating existing bottlenecks in energy and labour markets as well as disrupting supply chains further. And monetary optics may matter if you want to prevent commensurate wage rises feeding more demand-driven inflation down the road.

But here's where markets question the BoE and its G7 peers - positing that when the economy "normalises", the same pre-pandemic disinflation pressure will re-emerge. And so the sooner hiking starts, the lower the rate rise horizon ahead.

It will only take two more quarter point hikes next year to get back to where policy rates were before the pandemic and money markets are already priced for three. But at least four were priced a little over a month ago and the flattening of the money market and bond rate curves further suggest that dynamic is underway.

"There's still way too much priced into the UK interest rate curve for an economy that's still relatively fragile," said Gergely Majoros at French asset manager Carmignac.



Fidelity portfolio manager Sajiv Vaid also doubts the BoE's ability to follow through with a full-blown hiking cycle, sees 1% market pricing for next year as excessive and points to implied rates from the futures curve peaking below 1.2% in 2023 and then falling back below 1% over the following two years.

"The market thinks the BoE hiking as much as indicated is a mistake," he said.

Another harbinger of economic trouble to come is the flattening 2-10 year UK government bond yield curve. At just 24 basis points, that gap between short and long-term rates has more than halved since the Bank started talking tough in the autumn and is less than a quarter point from another worrying inversion seen just before the pandemic as formal Brexit neared.

To be fair, this disjoint between market pricing over the years ahead and what central banks are signalling is common to most of the G7 - not least in the United States.

It is based on an assumption that inflation will ultimately subside again over time even even if it's higher and more durable than first thought now - and also that global mega trends of ageing demographics, technology and trade will grind price rises back lower again. All that higher inflation will have done in the meantime is sap real incomes and potential growth further.

And yet Britain has its own peculiar difficulties on top of all that - making it all the stranger that it's the one to jump the rate hike gun.

Invesco multi-asset fund manager Georgina Taylor reckons the British bank faces bigger dilemmas than other central banks and that makes its decision-making harder - it has more of a problem with Omicron shorter term, more complicated supply chain and labour market problems related to Brexit and a structurally higher inflation profile to boot.

"The markets are telling us that the BoE is at risk of making a policy mistake," she said, adding this could even see sterling weakening into further hikes. "This could lead to a volatile period for UK assets."

Of course part of the problem is the tendency for investors to assume a normal full-blown economic and monetary policy cycle around the COVID shock, rather than seeing the crisis as more akin to an elongated natural disaster.

And if it's the latter, then maybe the only target worth considering is getting back to square one quickly once the disease has passed and then thinking again - moving rates and other monetary stimuli just to pre-pandemic settings and then assessing any lasting economic fallout.

This may well be all that markets are trying to say.


(The author is editor-at-large for finance and markets at Reuters News. Any views expressed here are his own)

(By Mike Dolan, Twitter: @reutersMikeD Editing by Frances Kerry) ((mike.dolan@thomsonreuters.com; +44 207 542 8488;))