When should rates rise?

The UK economy has finally returned to the level of output that, as a nation, we were achieving in 2008 following what has been one of the longest and deepest recessions since the Great Depression of the 1930s.

Although the economy as a whole is now 0.2% larger than at its previous pre-recession peak, some sectors of the economy are still some way off their former levels of output. Construction and some parts of manufacturing, the car industry in particular are performing relatively strongly now, though they represent a smaller slice of the nation’s output than they previously did due to the damage inflicted on them by the financial crisis.

The latest data published by the Office for National Statistics (ONS) suggests GDP growth in the second quarter of 2014 was 0.8% and the full year forecast is now an impressive 3.2%, a rise from the previous estimate of 2.9% several months ago showing that the recovery is continuing to build momentum.

More than 900,000 jobs have been created in the last twelve months, a pace of job creation not seen since the end of the Second World War. With the unemployment rate now at an estimated 6.6% of the working population and with no sign of any significant rise in wage growth, the Monetary Policy Committee (MPC) are still unanimous in refraining from external pressure to raise interest rates, with the July MPC meeting minutes showing that all nine members voted to retain the 0.5% bank base rate.

A number of commentators are suggesting that with the recovery now fully established, now is the time to be raising interest rates even if it is only in very small steps, perhaps by only 0.10% or 0.15% rather than the full quarter or half percent that has tended to have been applied historically.

Mark Carney has come in for some fairly considerable levels of criticism from some sectors of the media in relation to his comments on forward guidance, and his move to appear to move the goal posts.

Personally, I think that much of the criticism of him is unwarranted.

Twelve months ago when he delivered his speech in which he attempted to lay out his policy on forward guidance (hailed at the time as progressive for the BoE) as to the conditions, timing and degree of future interest rate increases, one of his key barometers in considering any possible rise in base rates was the rate of unemployment, and at that time it measured around 7.8%.

All of the economic data twelve months ago, generated both within the UK, amongst government and independent forecasting units, and externally including the IMF and World Bank, was predicting that the UK’s rate of growth and job creation would result in the unemployment rate reaching the 7% mark was most likely some time latterly in 2015 or even early 2016.

Within three months of that speech the economic landscape had changed considerably. Although the Governor then sought to adjust his policy whereby he effectively abandoned the 7% unemployment rate as a measure; in considering a possible rise in interest rates, the economy had grown at such pace, and job creation had been far greater and faster than anyone had forecast, that much of his policy had been superseded.

Some may argue that as Governor, that is what he is paid to forecast and to be more accurate than his peers. To a large degree, what has taken place in the UK economy has belied the normal rules of economics in that as unemployment has fallen at an increasing pace, wage growth continues to run at a modest 0.7%, yet we have a rate of Consumer Price Inflation of 1.9%.

Historically, when the job market starts to tighten, the level of wage growth starts to increase and generally ahead of the rate of inflation. When these conditions occur or in anticipation of this occurring central banks have tended to raise interest rates to slow growth and or curb consumer spending.

That is clearly not yet happening as wages in real terms are buying consumers less, but as that slack in the economy is squeezed further we are likely to see the gap between wage growth and inflation narrow.

The MPC are faced with a difficult conundrum of when and by how much to raise rates by, as increasing too early may damage the recovery if the increased cost of servicing debt impacts too severely on what are still largely declining disposable incomes.

As we move nearer to the general election there is also a political aspect that could be read into the timing of any rise in base rates which could help or hinder both of the main political parties in their attempts to be elected to form the next government but we will discuss that further next time.

Tags: , , , , , , , , ,

Comments are closed.