The Bank of England is expected to raise interest rates to 4% on Thursday, and the AI investment boom will revise the “neutral interest rate” judgment

The Zhitong Finance App learned that the market generally expects the Bank of England to raise interest rates by 25 basis points to 4.00% on November 5 (Thursday). This will be the first rate hike since August 2023. Behind this expectation is a quiet shift in the Bank of England's judgment on “neutral interest rates”: previously it believed that interest rates were high enough to curb inflation, but now they are no longer so certain.

Before the interest rate resolution was announced on Thursday, officials had been struggling with a symbolic question: For the British economy, what kind of interest rate level would be considered basically neutral, neither stimulating nor inhibiting growth? The surge in investment — much of it stemming from the AI race — is increasingly convincing policymakers that the so-called R-star (theoretical neutral interest rate) is now higher than before. This means that to maintain inflation at the central bank's target level of 2%, interest rates need to be higher than previously anticipated.

The energy shock brought about by the US-Iran war is expected to push consumer price inflation above 4% at the beginning of next year, and the surprisingly strong growth of the British economy further supports the judgment that “current interest rates are insufficient to contain cost pressure.”

“If you look at the changes that are taking place in the investment cycle, especially the AI cycle, are we seeing an increase in so-called R-star and neutral interest rates as a result?” Bank of England Governor Andrew Bailey asked this question at the International Finance Association panel discussion in Bangkok last month.

This poses difficult questions for Bailey and his colleagues as they prepare for this week's decisions. Economists and investors expect interest rates to be raised by 25 basis points to 4% on November 5, the first of many rate hikes over the next year. The Federal Reserve and the European Central Bank have tightened their policies and are expected to continue.

Jan Fliger, the former Bank of England interest rate setter and current vice chairman of hedge fund Millennium, is clear. While attending an event at the British National Institute of Economics and Social Research on September 24, he said that currently R-star is about 3.5%, and as long as energy prices remain high, interest rates will need to reach 4.5%.

“In the face of energy shocks, the economy showed far more resilience than most people, including me, expected,” Fliger said. “A more resilient economy and a slower deflation process is consistent with the policy stance of the past year or so being more relaxed than we previously thought.”

Growing “top students” in the G7

Despite a sharp rise in vehicle fuel prices, mortgage interest rates, and energy bills, the UK economy is still running at full speed.

The three-month economic growth rate to August was 0.7%, and the labor market is showing signs of stabilization after two years of downturn. The unemployment rate fell to 4.7%, the lowest level since mid-2025, and employers added 13,000 new jobs in September. The UK's economic growth in the first half of the year was on par with that of the US and surpassed that of all other G7 members, with AI investments estimated to have contributed significantly.

Bailey revealed that before the Middle East conflict broke out, he expected to cut interest rates twice this year. However, the reality is that interest rates remain at 3.75%.

Flieger was one of the more dovish members during his six-year term on the committee, which made his hawkish warning all the more compelling. Unsurprisingly, current monetary policy committee hawks, such as chief economist Hugh Peel and outside member Megan Greene, agree.

“A higher R-star means that your previous policies may not be as tight as you think,” Peale said at an event on October 15. “Maybe the average interest rate will be slightly higher.” Greene, on the other hand, said that faster growth and a stronger job market prove that policies are not as strong as expected to curb inflation.

Investment boom and debt expansion drive up borrowing costs

The argument that neutral interest rates are higher today depends not only on AI infrastructure, but also on government debt financing expenses.

According to Moody's data, by 2030, hyperscale technology companies will invest around $3 trillion in chips and data centers to seize competitive advantage. Meanwhile, the International Monetary Fund predicts that G7 countries' government debt as a share of GDP will rise from 94% to 102% due to increased national spending on defense and population aging, and the amount of loans will reach about 4.5 trillion US dollars in current currency values.

This scale is disrupting global macroeconomic forces. Economists estimate a neutral interest rate by weighing the balance between savings and investment. An excess of savings means a lower R-star, and the opposite is true of an investment frenzy.

Economist Jamie Rush said, “Over the past few decades, the factors that have kept borrowing costs low — abundant savings, scarce investment opportunities, and the world's trust in the US as their banker — have been changing. Like any other price, the price of capital is determined by supply and demand.”

TS Lombard global economist Dario Perkins pointed out this week that “the AI investment boom is rapidly becoming one of the biggest infrastructure projects in history.” According to what Google DeepMind researcher Finn Muirhouse posted on social media, US data center construction accounts for a share of GDP. It is progressing faster than the Apollo space program in the 1960s, which is almost equivalent to the American railroad boom in the mid-19th century and the Marshall Plan to rebuild Europe after World War II.

“The money is being spent,” Fliger said. Since the pandemic, the UK economy has grown by 6%, and consumption has grown more slowly, at just 2%, but investment has increased 16% and exports of services have increased by 41%.

“The recovery driven by exports and investment is likely to mean that global factors are at play,” he said.

According to calculations from the UK's National Institute of Economics 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 higher risk premiums. Only 40% is a direct response to rising energy costs due to the conflict in the Middle East.

“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.

According to a survey of market participants by the Bank of England last month, the average estimate of neutral interest rates is 3.25%. Rob Wood, UK's chief economist at Pantheon Macroeconomics, said that a model designed by the US Richmond Federal Reserve shows that the UK's R-star is 3.75%, and probably even higher.

Regardless of the exact numbers, there is a growing consensus that neutral interest rates have risen, and everyone, from politicians to the general public, needs to adapt to this new normal.