What next for interest rates?

Posted on September 2, 2014 by - Investment, News

Why the days of ultra-low interest rates look numbered

Inflation figures recently showed a sharper than expected drop in prices, cementing expectations that any rise in interest rates would be delayed until next year.

‘Smart’ money
Until recently, the ‘smart’ money has been on a November rate rise. However, given the Bank of England’s weaker outlook for wages, the current consensus among economists is now that rates will only rise in the first quarter of 2015.

Expectations are for a February rate rise, when the inflation report is published, although some argue that interest rates could stay low until after the general election.

The Bank is wary of increasing borrowing costs before households are better able to afford them, with Bank of England governor Mark Carney emphasising the UK’s feeble wage growth as a major concern in the latest quarterly inflation report.

Breeding confusion
As the future path of interest rates becomes murkier, is the Bank of England’s concept of ‘forward guidance’ working? Many argue that this policy, designed to give certainty on the direction of interest rates, is instead breeding more confusion.

Turn the clock back to August 2013: Mr Carney had recently taken over the reins as Bank of England governor and introduced the concept of forward guidance as a reliable way of indicating the Bank’s thinking on the direction of interest rates. The idea was to help consumers and businesses plan for the future.

Under Mr Carney’s first version of forward guidance, ultra-low interest rates were here to stay unless the unemployment rate dipped to below 7%. This was not expected to happen until 2016. But then the economic growth picked up and the jobless rate fell much quicker than anyone had expected. So, six months after first implementing forward guidance, Mr Carney overhauled his forward guidance policy.

Wage growth
Under forward guidance 2.0, the focus shifted to ‘slack’ in the economy – the amount of additional growth that can be delivered without putting upward pressure on inflation. This would be measured by a broader range of indicators.

We recently appeared to have moved to yet another version of forward guidance. With unemployment falling sharply and UK growth likely to pass the 3% mark – double the average rate since the financial crisis – Mr Carney’s focus has shifted to wage growth, with the governor highlighting the feeble growth in earnings as the Bank’s main concern and a significant factor in deciding when to raise interest rates.

Avoiding the issue
As Mr Carney moves from one measure to another, he seems to avoid addressing the issue of whether the UK’s recovery is unbalanced. Growth in the economy has been centred on the housing market and consumer spending, while improvements in manufacturing, business investment and exports have been unspectacular.

As such, it is perhaps unsurprising that British workers aren’t seeing the improving economy and labour market being reflected in their pay packets.

Financial bubble
The unbalanced nature of the recovery is important for a number of other reasons. As a start, such unbalanced growth makes the UK particularly vulnerable to higher interest rates. Even just a small rise in the Bank of England’s base rate could mean a disproportionate deterioration in the household finances of many, particularly those who have borrowed large sums.

On the flipside, if we are heading towards another financial bubble driven by excess borrowing, there is a case to be made for increasing rates to stop such a bubble from inflating even further. It could be that the Bank of England is caught in a classic catch-22 situation – damned if they do, and damned if they don’t.