The Bank of England Ponders a New Normal for Interest Rates

By Philip Aldrick, Tom Rees November 02, 2026 at 05:00 AM GMT+8

For most of this year, the Bank of England argued that interest rates were probably high enough to bear down on inflation. Now it’s not so sure.

Ahead of Thursday’s meeting, when the Monetary Policy Committee is expected to raise borrowing costs for the first time since 2023, officials have been grappling with a totemic question: what rate of interest is essentially neutral, neither stimulative nor restrictive, for the UK economy?

Surging investment, much of it due to the AI race, has increasingly convinced policymakers that R-star — as the theoretical rate’s also known — is now higher than it was. The implication is that interest rates need to be tighter than previously thought to keep inflation at the bank’s 2% target.

The energy shock from the US-Iran war is projected to push consumer-price inflation above 4% early next year, and the UK economy’s surprisingly strong growth has bolstered the case that rates are not high enough to rein in cost pressures.

“If you take what’s going on with the investment cycle, particularly with the AI cycle, are we seeing as a consequence of that an increase in so-called R-star and the neutral rate of interest?” Bank of England Governor Andrew Bailey pondered at an Institute of International Finance panel in Bangkok last month.

It raises difficult questions for Bailey and his fellow policymakers as they prepare for this week’s decision. Economists and investors expect a quarter-point hike to 4% on Nov. 5, the first of several over the coming year. The Federal Reserve and European Central Bank have already tightened policy and are expected to keep going.

Jan Vlieghe, a former BOE rate-setter and now a vice chairman at hedge fund Millennium, is unequivocal. Speaking at a National Institute of Economic and Social Research event on Sept. 24, he suggested that R-star is currently about 3.5% and rates need to be 4.5% as long as energy prices are elevated.

“The economy has turned out much more resilient than most people, including me, expected in the face of the energy shock,” Vlieghe said. “A more resilient economy and less disinflation is consistent with the policy stance over the past year or so having been less restrictive than we previously thought.”

Top of the G7

Despite a sharp increase in motor fuel prices, mortgage rates and energy bills, the UK economy is whirring.

Growth in the three months through August was a respectable 0.7% and the labor market is showing signs of stabilizing after a two-year downturn. Unemployment fell to 4.7%, the lowest level since mid-2025, and employers added 13,000 jobs in September.

UK growth matched the US and outpaced all other Group of Seven peers in the first half, with AI investment estimated to have made a significant contribution.

Bailey revealed that, before the Middle East conflict erupted, he expected rates to be cut twice this year. Instead, they remain at 3.75%.

Vlieghe was one of the more dovish members of the committee during his six years, which makes his hawkish warning all the more striking. Current MPC hawks such as chief economist Huw Pill and external member Megan Greene unsurprisingly agree.

“A higher R-star means perhaps that you have been less restrictive than you thought,” Pill said at a Reinventing Bretton Woods event on Oct. 15. “Maybe rates, on average, will be that little bit higher.” Greene said faster growth and a stronger jobs market are proof that policy is not bearing down on inflation as much as thought.

Investment Frenzy

The argument that the neutral rate of interest is higher today hinges on AI infrastructure, but also on debt-funded government spending.

Around $3 trillion will be poured into chips and data centers by 2030 as hyperscalers race to beat their rivals, according to Moody’s. Meanwhile, G7 nations will increase general government debt to 102% from 94% of GDP — a borrowing spree of around $4.5 trillion in today’s money — the International Monetary Fund forecasts, as nations spend more on defense and ageing populations.

Read more: AI’s $3 Trillion Build-Out Spurs Debt Boom and Creates New Risk

The scale is upending global macroeconomic forces. Economists extrapolate the neutral rate by weighing up the balance between savings and investment. A glut of savings suggests a lower R-star, an investment frenzy implies the opposite.

“The forces that held borrowing costs low for a generation — an abundance of savings, a scarcity of investment opportunities and a world that trusted the US to be its banker — are shifting,” Jamie Rush, Bloomberg Economics’ director of global economics, said. “Like any other price, the price of money is set by supply and demand.”

Dario Perkins, global economist at TS Lombard, noted this week that “the AI investment boom is rapidly becoming one of the largest infrastructure projects in history.” The pace of US data center roll-out as a share of GDP is faster than the 1960s Apollo space program and almost equivalent to the mid-1800s US railroad boom and Marshall Plan to rebuild Europe after the Second World War, according posts on social media by Fin Moorhouse, a researcher at Google Deepmind.

“Money is being spent,” said Vlieghe. Since the pandemic the UK economy has grown 6%, consumption an even more sluggish 2% — but investment is up 16% and services exports are up 41%, he said.

“There is something about an export and investment-driven recovery which makes it very likely that global factors here are at play.”

More than half of the rise in the UK’s benchmark borrowing costs this year can be attributed to the AI investment boom and investors demanding higher premiums, NIESR has calculated. Only 40% is a direct response to higher energy costs from the Middle East conflict.

“That casts a little bit of doubt on the idea that this is a temporary shock, and we may see higher interest rates persistently from here,” said NIESR director David Aikman.

A survey of market participants by the BOE last month put the average estimate of neutral at 3.25%. Rob Wood, chief UK economist at Pantheon Macroeconomics, said a model designed by the US Federal Reserve Bank of Richmond suggested the UK’s R-star is 3.75% and that it could even be higher.

Whatever the rate is, the growing consensus is that it has risen and everyone – from politicians to the general public – needs to get used to the new normal.