Bank of England Expected to Raise Rates to 4% on Thursday; AI Investment Boom Rewrites "Neutral Rate" Assumptions

The market widely expects the Bank of England to raise rates by 25 basis points to 4.00% on Thursday, November 5which would be the first hike since August 2023. Behind this expectation is a quiet shift in the BoE's judgment of the "neutral rate": it had previously believed rates were high enough to suppress inflation, but now it is no longer so certain. Ahead of Thursday's rate decision, officials have been grappling with a symbolic question: what level of interest rates is roughly neutral for the UK economyneither stimulating nor suppressing growth? The investment surgemuch of it driven by the AI raceis increasingly convincing policymakers that the so-called R-star (the theoretical neutral rate) is now higher than before. This means that to keep inflation at the central bank's 2% target, rates need to be higher than previously expected. The energy shock from the US-Iran war is expected to push consumer price inflation above 4% early next year, and the UK economy's unexpectedly strong growth further supports the judgment that "current rates are insufficient to curb cost pressures." "If you look at the changes taking place in the investment cycle, particularly the AI cycle, are we therefore seeing a rise in what is called R-star and the neutral rate?" Bank of England Governor Andrew Bailey asked at an Institute of International Finance panel discussion in Bangkok last month. This poses tricky questions for Bailey and his colleagues as they prepare for this week's decision. Economists and investors expect a 25 basis point hike to 4% on November 5, the first of several hikes over the coming year. The Federal Reserve and the European Central Bank have already tightened policy and are expected to continue. Former BoE rate-setter and current Millennium hedge fund vice chairman Jan Vlieghe is unequivocal. Speaking at a National Institute of Economic and Social Research event on September 24, he said R-star is currently around 3.5%, and as long as energy prices remain elevated, rates will need to reach 4.5%. "In the face of the energy shock, the economy has shown far more resilience than most people, including me, expected," Vlieghe said. "A more resilient economy and a slower disinflation process are consistent with the policy stance over the past year or so having been looser than we previously thought." Growth "star pupil" among the G7 Despite sharp rises in motor fuel prices, mortgage rates and energy bills, the UK economy is still running at full speed. Growth in the three months to August was 0.7%, and the labor market is showing signs of stabilizing after a two-year slump. The unemployment rate fell to 4.7%, the lowest since mid-2025, with employers adding 13,000 jobs in September. UK growth in the first half matched that of the US and outpaced all other G7 members, with AI investment estimated to have made a significant contribution. Bailey revealed that before the Middle East conflict broke out, he had expected two rate cuts this year. But in reality, rates remain at 3.75%. Vlieghe was one of the more dovish members during his six-year tenure on the committee, making his hawkish warning all the more notable. Unsurprisingly, current Monetary Policy Committee hawks such as Chief Economist Huw Pill and external member Megan Greene also agree. "A higher R-star means your policy may not have been as tight as you thought," Pill said at an event on October 15. "Perhaps the average level of rates will be slightly higher." Greene said faster growth and a stronger job market prove that policy is suppressing inflation less than expected. Investment boom and debt expansion push up borrowing costs The argument that the neutral rate is now higher depends not only on AI infrastructure but also on government debt-financed spending. According to Moody's data, hyperscale tech companies will invest about $3 trillion in chips and data centers by 2030 to seize competitive advantage. Meanwhile, the International Monetary Fund forecasts that G7 government debt as a share of GDP will rise from 94% to 102% due to increased spending on defense and aging populations, with borrowing amounting to about $4.5 trillion at current values. This scale is upending global macroeconomic forces. Economists infer the neutral rate by weighing the balance between savings and investment. A savings glut means a lower R-star; an investment boom means the opposite. Economist Jamie Rush said: "The factors that kept borrowing costs low over the past few decadesample savings, scarce investment opportunities, and the world's trust in the US as its bankerare changing. Like any other price, the price of money is determined by supply and demand." TS Lombard global economist Dario Perkins noted this week that "the AI investment boom is rapidly becoming one of the largest infrastructure projects in history." According to a social media post by Google DeepMind researcher Finn Moorhouse, US data center construction as a share of GDP is advancing faster than the Apollo space program of the 1960s, roughly comparable to the mid-19th century US railroad boom and the Marshall Plan that rebuilt Europe after World War II. "Money is being spent," Vlieghe said. Since the pandemic, the UK economy has grown 6%, consumption growth has been slower at just 2%, but investment has risen 16% and services exports have grown 41%. He said: "A recovery driven by exports and investment likely means global factors are at play." According to NIESR calculations, more than half of the rise in UK benchmark borrowing costs this year can be attributed to the AI investment boom and investors demanding a higher risk premium. Only 40% is a direct response to higher energy costs caused by the Middle East conflict. "This casts some doubt on the idea that 'this is just a temporary shock,' and we may see rates continue to rise from current levels," said NIESR director David Aikman. A BoE survey of market participants last month showed an average estimate for the neutral rate of 3.25%. Pantheon Macroeconomics UK chief economist Rob Wood said a model designed by the Federal Reserve Bank of Richmond shows the UK's R-star at 3.75%, and possibly even higher. Whatever the exact number, there is growing consensus that the neutral rate has risen, and everyone from politicians to the general public needs to adapt to this new normal.