The market widely expects the Bank of England to raise interest rates by 25 basis points to 4.00% on Thursday, November 5, which would mark the first rate hike since August 2023.
Behind this expectation lies a quiet shift in the Bank of England's judgment on the "neutral rate": it 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 essentially neutral for the UK economy, neither stimulating nor restraining growth?
A surge in investment — much of it driven by the AI race — is 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, interest 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, while the UK economy's surprisingly strong growth further supports the judgment that current rates are insufficient to curb cost pressures.
"If you look at what's happening 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 IIF panel discussion in Bangkok last month.
This poses thorny 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 multiple increases over the coming year.
The Federal Reserve and the European Central Bank have already tightened policy and are expected to continue.
Former Bank of England 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%.
"The economy has shown far more resilience in the face of the energy shock than most people, including myself, expected," Vlieghe said.
"A more resilient economy and a slower disinflation process are consistent with policy having been looser over the past year or so than we previously thought."
Growth 'Top Performer' Among G7
Despite sharp increases in motor fuel prices, mortgage rates and energy bills, the UK economy is still running at full speed.
Growth in the three months through 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 economic growth in the first half matched that of the United States and exceeded all other G7 members, with AI investment estimated to have made a significant contribution.
Bailey revealed that before the Middle East conflict erupted, he 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 committee tenure, making his hawkish warning all the more notable.
As expected, current Monetary Policy Committee hawks such as Chief Economist Huw Pill and external member Megan Greene have also voiced agreement.
"A higher R-star means your previous policy may not have been as tight as you thought," Pill said at an event on October 15.
"Perhaps the average level of interest rates will be slightly higher."
Greene said faster growth and a stronger job market prove that policy has been less effective at suppressing inflation 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, by 2030, hyperscale tech companies will spend approximately $3 trillion on chips and data centers to secure 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 reaching about $4.5 trillion in current currency terms.
This scale is upending global macroeconomic forces.
Economists calculate the neutral rate by weighing the balance between savings and investment.
A savings glut means a lower R-star, while an investment frenzy does the opposite.
Economist Jamie Rush said: "The factors that kept borrowing costs low over the past few decades — abundant savings, scarce investment opportunities, and countries around the world trusting the US as their banker — are 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 content posted on social media 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 equivalent to the US railway boom of the mid-19th century and the Marshall Plan for rebuilding Europe after World War II.
"The 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 is likely to mean global factors are at play."
According to calculations by the National Institute of Economic and Social Research, more than half of the increase 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 rising 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 interest rates continuing to rise from current levels," said NIESR director David Aikman.
A Bank of England survey of market participants last month showed the average estimate for the neutral rate was 3.25%.
Pantheon Macroeconomics chief UK economist Rob Wood said a model designed by the US Richmond Fed shows the UK's R-star is 3.75%, and possibly even higher.
Whatever the exact figure, there is a growing consensus: the neutral rate has risen, and everyone from politicians to the general public needs to adapt to this new normal.
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