Bank of England expected to raise interest rates to 4% on Thursday; AI investment boom rewrites expectations for the "neutral rate"

According to Zhitong Finance APP, the market generally expects the Bank of England to raise interest rates by 25 basis points to 4.00% on November 5th (Thursday), which would be the first rate hike since August 2023. Behind this expectation is the Bank of England's subtle shift in its view of the “neutral interest rate”: it previously believed rates were already high enough to contain inflation, but is now less certain.

Before the rate decision announcement on Thursday, officials have been grappling with a symbolic question: for the UK economy, what interest rate level can be considered basically neutral, neither stimulating nor curbing growth? The 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 in the past. This means that to keep inflation at the Bank’s 2% target, rates will 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’s unexpectedly strong economic growth further supports the judgment that “current interest rates are insufficient to contain cost pressures.”

“If you look at what’s happening in the investment cycle, especially the AI cycle, are we therefore seeing a rise in the so-called R-star and neutral rates?” Bank of England Governor Andrew Bailey posed this question last month at a panel discussion held by the Institute of International Finance in Bangkok.

This presents a thorny problem 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 in a series of hikes over the next year. The Federal Reserve and European Central Bank have already tightened policy and are expected to continue.

Former Bank of England rate setter and current vice chairman at the hedge fund Millennium, Jan Vlieghe, is clear in his stance. Speaking at a National Institute of Economic and Social Research event on September 24, he said the R-star is currently around 3.5%, and as long as energy prices remain elevated, rates need to reach 4.5%.

“Faced with the energy shock, the economy has shown resilience far beyond most people’s expectations, including my own,” Vlieghe said. “A more resilient economy and slower disinflation process are consistent with the policy stance over the past year or so being looser than we previously thought.”

“Top Performer” in Growth Among the G7

Despite sharp rises in motor fuel prices, mortgage rates, and energy bills, the UK economy continues to run at full speed.

The three-month economic growth rate to August was 0.7%, and the labor market, after two years of weakness, is showing signs of stabilizing. The unemployment rate fell to 4.7%, the lowest since mid-2025, and employers added 13,000 jobs in September. The UK’s economic growth in the first half of the year matched that of the United States and surpassed all other G7 members, with AI investment estimated to have played a significant role.

Bailey revealed that before the outbreak of conflict in the Middle East, he had expected two rate cuts this year. In reality, rates remain at 3.75%.

Vlieghe was one of the more dovish members during his six-year term on the committee, making his current hawkish warning all the more notable. Unsurprisingly, current hawkish members on the Monetary Policy Committee, such as Chief Economist Huw Pill and external member Megan Greene, agree with this view.

“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 interest rate level will be a little higher.” Greene stated that faster growth and a stronger jobs market show that policy has had less of a restraining effect on inflation than expected.

Investment Boom and Debt Expansion Push Up Borrowing Costs

The argument for a higher neutral rate now depends not only on AI infrastructure but also on government debt-financed spending.

According to Moody’s data, by 2030, mega tech companies will invest about US$3 trillion in chips and data centers in the battle for competitive advantage. At the same time, the International Monetary Fund predicts that with rising spending on defense and population aging, the G7’s government debt as a percentage of GDP will increase from 94% to 102%, with the amount borrowed reaching about US$4.5 trillion at current values.

This scale is disrupting global macroeconomic forces. Economists estimate the neutral rate by weighing the balance between savings and investment. Excess savings imply a lower R-star, whereas an investment boom does the opposite.

“Over the past few decades, the factors that kept borrowing costs low—ample savings, scarce investment opportunities, and the world’s trust in the US as its banker—are changing. Like any other price, the price of money is determined by supply and demand,” said economist Jamie Rush.

TS Lombard global economist Dario Perkins noted this week that “the AI investment boom is quickly becoming one of the largest infrastructure projects in history.” According to content posted on social media by Google DeepMind researcher Finn Mulhouse, the US data center construction share of GDP is rising faster than the Apollo space program in the 1960s, and is almost comparable to the US railroad boom in the mid-19th century and the Marshall Plan that rebuilt Europe after WWII.

“The money is being spent,” Vlieghe said. Since the pandemic, the UK economy has grown by 6%, with consumer spending rising just 2%, but investment has increased by 16%, and services exports by 41%.

He said: “Recovery driven by exports and investment likely means global factors are at play.”

According to calculations by the National Institute of Economic and Social Research, more than half of the increase in the UK’s 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 the rise in energy costs due to the Middle East conflict.

“This raises some doubts about the idea that ‘this is just a temporary shock’, and we may see interest rates continue to rise from current levels,” said David Aikman, director of the institute.

A survey by the Bank of England of market participants last month showed the average estimate for the neutral rate is 3.25%. Rob Wood, chief UK economist at Pantheon Macroeconomics, said a model devised by the Federal Reserve Bank of Richmond puts the UK’s R-star at 3.75%, or possibly even higher.

No matter what the precise number, a growing consensus is emerging: the neutral rate has risen, and from politicians to the general public, everyone will need to adapt to this new normal.