12 August 2014

What is the Bank of England thinking?

UK unemployment is at an all-time low and inflation is close to the Bank of England’s 2% inflation target, yet interest rates remain at their lowest level in history. What is going on behind closed doors at Threadneedle Street?
  • ​​​​​​New normal will for interest rates will be around 2.5 percent​
  • Productivity has been uncharacteristically weak since the recession
  • First rate hike expected by the end of this year

Business leaders in the UK may be convinced that the time has come to raise rates, but it’s certainly not the feeling at the Bank of England.

There seems to be increasing confusion over the timing of a rate hike. Markets have been awash with speculation for the central bank to increase its benchmark lending rate this year, but there is as yet no firm commitment.

Last year was different. Back then governor Mark Carney, flushed with his successes at the Bank of Canada, guided markets to expect the 0.5 per cent level to remain in place until 2016.

It was all about when the unemployment rate improved, only it didn’t prove that simple. Jobs have been created all over the place and the UK unemployment rate has tumbled.

With jobs being created faster than could have been predicted, Mr Carney was forced to step back from this sort of narrow forward guidance and leave it up to a broader economic indicators.

Debate over the timing of a rate rise has intensified, with Bank governor Mark Carney hinting recently that it could come by the end of this year. Photo: Shutterstock 

Latest minutes from the Bank’s all-powerful Monetary Policy Committee indicate that not a lot has changed. There is no “preset course” for hiking rates, they say, echoing the sort of rhetoric Ben Bernanke employed for the much-awaited Fed taper last year.

“The committee agreed that no increase was warranted at this meeting, although for some members the decision had become more balanced in the past few months than earlier in the year,” the minutes read.

So what does more balanced mean? Clearly there are some in the MPC who are coming round to the idea of raising rates.

It was Mark Carney himself who lit the touchpaper earlier this year when, in remarks at his annual Mansion House speech in the City of London, he suggested a hike in the bank base rate could occur “sooner than markets currently expect”.

“There’s already great speculation about the exact timing of the first rate hike and this decision is becoming more balanced,” Mr Carney said. “It could happen sooner than markets currently expect.”

Housing risks

Risks remain and many are cautious. Mr Carney has expressly warned of housing debt risk as a rise in rates catches homeowners.

Jon Cunliffe, deputy governor for financial stability, noted recently how “continued momentum in the housing market could pose to household indebtedness and hence to the economy and to financial stability”.

At 135 percent of income, average household debts in the UK are pretty high. The problem for the bank is that lifting rates could send many people into trouble. But it could be argued that this is a question more of the pace of increase - the market has already decided that rates will rise in the coming months, the real question is how quickly they will return to the ‘normal’ levels.

Mr Carney has suggested the new normal will be around 2.5 percent and that any increase will be “gradual and limited”.

But for someone who’s just taken out a mortgage even a small rise in rates could be tricky. Indeed recent experience from the US shows us just what could happen if the Bank started bandying around mega interest rate hikes.

In the middle of 2013, long-term US interest rates rose by around one percentage point on the expectation of a tapering in US monetary policy, the so-called “taper tantrum”.

The impact on the US housing market was massive, with sales seven percent  lower than a year ago and residential investment falling in each of the last few quarters.

Andrew Haldane, the Bank’s chief economist, highlights the possibility “of borrowers reacting more sharply to rate rises now than in the past”. The MPC needs to tread carefully.

Productivity puzzle

Another factor weighing on the bank’s plans to increase lending costs is the rather puzzling picture of UK productivity.

Ian McCafferty, external member of the MPC, suggests that while the UK has enjoyed a “remarkable recovery” that “caught many by surprise”, productivity performance seems to be behind the curve.

"Productivity has been extremely and uncharacteristically weak since the end of the recession in mid-2009, compared with the episodes of the 1980s and 1990s," he says.

Recent economic surveys have suggested the UK service sector is continuing to grow robustly, although there are signs that growth in the manufacturing sector has slowed.​ Photo: Shutterstock 

So, what are the implications of this for monetary policy?

“The key issues currently facing the MPC are estimating the current level of slack, and the pace at which it will be absorbed as the recovery develops,” says McCafferty, who adds that the bank’s current judgment is that productivity will recover as demand strengthens.

However, the rate of productivity growth over the next two years is “unlikely to materially exceed pre-crisis rates”.

Faced with such uncertainties about the likely pace of absorption of slack, he argues for removing “some of the current extraordinary level of monetary stimulus a little before the output gap is fully closed” Does this make him a hawk?

Perhaps. He goes on to say there is an additional reason not to hold back too long: “It will be critically important that rises in Bank Rate are delivered, as far as we are able, at only a modest, gradual pace. This will be necessary to allow consumers and businesses, who are likely to be more than normally sensitive to changes in interest rates in the early stages of the tightening cycle, to adapt without undue disruption to spending or damage to confidence.”

As ever, like a nervous tic that seems to be afflicting all central bankers, he says any decision will “depend critically on the evolution of the data over the coming months”.

Wage gap

MPC member Martin Weale says there is a “contradictory” nature to the economy - GDP and jobs are growing fast while wages remain in check.

Reacting to this is similarly about striking a balance between two opposing forces. He suggests that “should wage growth fail to revive, that will, on its own, tip the scales further in favour of maintaining a strong monetary stimulus”.

He goes on to suggest that “a slightly less stimulatory monetary policy will still be making a very substantial contribution to ensuring that that spare capacity is absorbed”.

Largely this sort of thing is for the central bankers to hammer out and discuss round the meeting table each month. But Mr Weale’s final comment on this does offer a clue as to where the bank sits on the fence at present.

“Moreover, other things being equal, the policy of raising Bank Rate gradually does imply that the first rise needs to come sooner than would otherwise be the case,” he said. In other words, if normalisation is to occur slowly the process has to start sooner rather than later.

Where do we stand?

Andrew Haldane, the bank’s chief economist, notes that in January 2013, the first rise in UK interest rates was expected in the third quarter of 2015. Now, it is expected by the end of this year.

“This prospect has sent shivers down some spines. But some context is important here. When the first rate rise does come, it will be because the economy has recovered sufficiently to thrive on smaller doses of monetary medicine,” he says.

But at least the MPC at least seems to be speaking pretty much with one voice. Hawks and doves are in line at present.

Mr Haldane says they agree that any rate rise “need not be immediate, that when rate rises come they are intended to be gradual and that interest rates in the medium-term are likely to be somewhat lower than their historical average”.

It seems the bank continues to play the waiting game; but it will have to crack sooner or later.

Ultimately, the timing of a rate rise is hard to predict, but more importantly it seems the outcome of normalisation is even tougher to forecast, which may be why the MPC is so reluctant to act quickly and decisively as businesses are demanding. As Mr Haldane puts it, monetary policy is in “unknown territory”.​

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