Interesting Times

John Phillips talks about the future of Interest Rates.

Anyone following the debate regarding UK interest rates in the past year or so will know that while on the the surface all has been calm, there has been some furious paddling beneath. As I write this, the Bank Of England interest rate is still stuck at 0.5 per cent, where it has been since March 2009.

We have become accustomed to extremely low rates. The Bank of England has been with us since1694, but until 2009 the interest rate in the UK had never been below 2 per cent. We are now experiencing the longest period of unchanged interest rates since the 1940s,after which time rates finally began to rise from wartime emergency levels.

The emergency this time has been financial rather than military, but the time it has taken even to contemplate a rise in interest rates is testimony to the severity of the UK crisis. In August 2013, Mark Carney newly installed as the governor of the Bank of England launched his forward guidance, which implied no rate hike until 2016.

However, time has moved on and the UK”s  recovery has gained significantly in strength since Carney’s announcement. The Bank’s Monetary Policy Committee {MPC} has shifted from its initial emphasis on unemployment -  which has fallen sharply- to more general measures of “ slack “ in the economy, such as spare capacity. Pressure is being put on the Bank to take off the emergency interest rate settings because the UK”s economic growth has been stronger than expected. This raises several questions, not least whether interest rates should be rising at all, and whether all banks will raise rates. In the UK,, unusually, this is not to do with whether inflation is above or below official 2 per cent target. Rather, it depends on which aspect of the labour market the Bank regards as more important. If the MPC concentrates on fast -falling unemployment and indicators such as vacancies and skill shortages, which suggest the market is tightening, it will raise rates soon. But if it looks at other labour market statistics and focuses on very weak growth in wages- which are not even keeping up with below – target inflation rate-it will hold fire.

Economists predict wage growth to gain strength and for pay to rise faster than prices as we move into 2015, but we don’t yet have the evidence and so delay is likely. if not necessarily for long. Even when rates rise in the UK, they are unlikely to do so rapidly. Every bit of market guidance from the Bank has been about the gradual nature of its rate- hiking strategy when it begins. The MPC is aware that when it announces the first hike after such a long period of inactivity, financial markets will be tempted to price in many further increases, and to assume they could happen quickly. The Bank’s message will be that it will occur slowly, probably no more than a quarter-point increase every three months.

So where will interest rates end up eventually? There is, of course, a wide range of interest rates available in the economy for savers and borrowers. When it comes to the Bank interest rate, however, the MPC has in mind a much lower level than in the past.     IF you can remember the pre- crisis period, a 5 per cent rate was the norm. After  the crisis, and for some time to come, the Bank is aiming for no higher than 2.5 per cent.

As we all know the best laid plans can go astray, of course “ Limited and gradual” has been the message on rate rises  from Mark Carney and his Bank colleagues.

The big question is whether they can achieve it.

John Phillips Winter Message on UK,s Interest Rates.


John Phillips