Markets have a tendency to panic when central banks threaten to raise interest rates. In 2014, the US Federal Reserve and its then boss, Ben Bernanke, senttraders across the world into a spin when he merely hinted that the era of almost zero rates might be ending.
It’s been a decade since the Bank of England last increased the cost of borrowing, so it is no surprise that this week’s vote by the monetary policy committee, which Threadneedle Street has sketched out as a good moment for a rise, is being closely watched.
Nine committee members hold the key to unlocking 10 years of ultra-low rates – with five drawn from the Bank’s payroll and four external members from industry and the City. The latter serve a three-year stint, which is often extended to six years.
Bank of England governor Mark Carney is among many on the MPC to have hinted that 2 November will be the day the Bank should at least reverse its emergency 0.25% set in August 2016, which was designed to ensure that the economy did not take a dive in the wake of the Brexit vote. And having listened to one carefully coded hint after another in recent months from what is clearly a majority of members, markets have judged that an increase is now almost nailed on – with a 90% probability.
However, the case for a rate rise, as Carney and his colleagues always stress, is finely balanced and could go either way once they have sieved through all the economic data. Here we consider the arguments for raising them versus the reasons to hold steady.
The case for higher rates
The Bank of England was set two targets when it was reconstituted by Gordon Brown in the late 1990s and granted the power to set interest rates independently: to maintain inflation at around 2% and to make sure that monetary policy kept the economy’s wheels turning.
In the past 10 years these have proved to be conflicting aims, because to raise rates has been seen as an almost certain way to kill off growth. That wouldn’t be the case in more normal times, but in the aftermath of the banking crash, with lenders initially strapped for funds and regulators concerned to keep the financial sector on a tight rein, low interest rates were seen as the only way to keep money flowing around the economy. And that is especially true when so much household spending is based on borrowed money.
So the second concern – to keep GDP expanding – has won out over the imperative to maintain inflation steady at 2%, and inflation has been allowed to soar to 5% – as it did in 2012, when the Bank sat firmly on its hands and did nothing.
Forecasts for inflation don’t show it going back to 2012 levels, but with a rate of 3% recorded in September and predictions of rises for at least the next couple of months, the Bank must consider increasing the cost of borrowing to reduce the demand for goods and services, and calm price rises.
Further price increases could already be in the pipeline, according to some MPC members, following the fall in unemployment to 4.3% in the three months to August. As Howard Archer, chief economic adviser to the EY Item Club, says, the joblessness rate is at its lowest since 1975 and well below the 4.5% equilibrium rate the Bank believes determines full employment and is the trigger for higher wages. With more money in their pockets, workers could be tempted to borrow and spend even more, adding to the pressure on prices.
It’s not just jobs: the economy has held up much better than most forecasters, including the Bank, predicted following the Brexit vote. It has grown throughout the year – when many thought it could fall into recession – after three previous years of growth. If the Bank won’t raise rates against this backdrop, then when?
Some economists also believe the bank should take the opportunity to raise rates now because it may need to cut them again the future. At 0.25%, the bank has no real leeway for a cut that would act as a stimulus. By raising rates – maybe once, maybe more – Threadneedle Street starts to rebuild its ammunition for use in a crisis.
And then there is the question of pride. This is a huge factor after months during which the Bank has prepared the ground for a rate rise. As Archer says: “If it fails again to follow through with a rate hike, it will risk losing credibility.”
It would also probably prompt a fall in the pound – which would stoke inflation even further.
Carney’s reputation as a modern-day Grand Old Duke of York is under particular scrutiny. He has used speeches and reports in the past to tell businesses and households that higher borrowing costs are imminent – only to retreat back down the mountain. It could be that his influence will wane should he refuse to make good on yet another threat.
The case for the status quo
The economy may have grown for almost four straight years, but the rate of growth has declined since its initial burst in late 2013 and is now the lowest of all major economies. Next year, the OECD says Italy and Japan, often derided as the zombie economies of the developed world, will grow faster than the UK.
Last week the Office for National Statistics said Britain grew by 0.4% in the third quarter of the year, compared with 0.3% in the first two quarters.
The MPC’s newest recruit, Sir David Ramsden, formerly the Treasury’s chief economic adviser, said in his confirmation hearing that given rates of growth almost half what they were in 2015, the economy was too weak to withstand higher borrowing costs.
With the government seeking to cut back on borrowing, and large corporations hoarding enough cash to avoid the need to borrow, driving up the cost of loans to consumers and small businesses could push the economy further towards zero growth.
Brexit is another reason to err on the side of caution and keep rates where they are. Consumers have already become more circumspect with their spending. High street surveys show consumers keeping their wallets shut unless there is a good reason to open them. The CBI’s latest figures showed the steepest fall in retail spending since the depths of the post-banking crisis recession in 2009. High street bellwethers John Lewis and Debenhams have both warned of challenging trading. Car sales have already plummeted, as have sales of furniture. According to the Halifax, confidence in the housing market is at a five-year low.
Chris Williamson of economics consultancy IHS Insight says the “slow erosion of growth” may continue. He points out that across all sectors of the economy, inflows of new business in September were at their lowest for 13 months, suggesting that demand for goods and services “has waned again”.
Business optimism is weak, he adds, which is another indication that businesses are about to suffer a further drop in activity and that the economy will slow “towards stagnation at best”.
Archer of the EY Item Club believes inflation is set to fall back markedly from around the turn of the year as the impact of past sharp falls in sterling fade. The weak pound has seen many businesses suffering a large rise in import costs, which a number have absorbed through lower profit margins and passed on to workers through sub-inflation wage rises. Nevertheless, prices have crept up. Without further falls in sterling, prices will stabilise on their own. An interest rate rise in this situation could make a bad situation worse.
It’s a danger Ramsden has been explicit about wanting to avoid. But pushing an already struggling economy, dogged by Brexit-related uncertainty, towards recession is not something any MPC member will want to be remembered for.
Where the MPC stands
A former hedge fund economist, Vlieghe, an external member of the MPC, said in August: “This is an environment where a premature hike would be a bigger mistake than one that turns out to be slightly late.” Last month he said the mood was changing: “The appropriate time for a rise in bank rate may be as early as in the coming months.” How hawkish? 8/10
A former professor at the London School of Economics, Tenreyro is a new appointee. At her first public engagement last month, she said: “We are approaching a tipping point when we will need to reduce some of that stimulus.” She added that unemployment still needed to be lower: “A premature increase might be very contractionary, so a mistake there might be very costly.” How hawkish? 6
Former Citibank economist Saunders voted for a rise in September, to dampen looming price pressures. In August he said: “Our foot no longer needs to be quite so firmly on the accelerator in my view. A modest rise in rates would help ensure a sustainable return of inflation to target.” How hawkish? 10
The former chief economic adviser at the CBI voted in July to raise the base rate from 0.25% to 0.5%. He has voted for a rise ever since, arguing that the “pick-up in inflation is not something we can just ignore”, especially when the “healthy performance of businesses in the past year shows the UK economy could cope with higher interest rates”. How hawkish? 10
Haldane was once a fervent supporter of low interest rates, but in the summer hinted that he was more inclined to start pushing them higher. In June, he said a partial withdrawal of the emergency post-Brexit package of an interest rate cutand an extra £60bn of quantitative easing “would be prudent relatively soon”. How hawkish? 6
In charge of markets and banking, the former Treasury economist says slowing growth and declining real wages mean now is not the time for a rate rise. He said last month: “Despite continued robust growth in employment, there is no sign of second-round effects [demands for higher pay] on to wages from higher recent inflation.” How hawkish? 2
In charge of financial stability at the Bank, Cunliffe is one of the committee’s most risk- averse members. Last month he told the Western Mail that the UK economy had “clearly slowed”, and that any rate rises would be gradual. As he put it: “The exact timing of when that starts? Well, that for me is a more open question.” How hawkish? 4
Responsible for monetary policy, Broadbent is a close confidant of Carney and keeps his cards close to his chest. In July he stressed the weakness of the economic outlook, saying: “It is a bit tricky at the moment to make a decision [to raise rates]. I am not ready to do it yet.” How hawkish? 6
Carney is expected to vote for a rise after saying in September that the “possibility has definitely increased”. To give a little more context to his decision, he said: “The majority of committee members, myself included, see that that balancing act is beginning to shift, and that … to return inflation to that 2% target in a sustainable manner, there may need to be some adjustment of interest rates.” How hawkish? 6
Source: The Guardian