Is an interest rate rise on the cards?
"To put them up, or not to put them up - that is the question." Warwickshire County Council's Economy & Skills Group Manager Dave Ayton-Hill explores the background to the vital but tangled conundrum of whether to raise interest rates.
Over the past few weeks, there has been increasing talk of an imminent rise in the interest rate set by the Bank of England.
At the last Monetary Policy Committee meeting in September, they agreed to keep interest rates at their record low of 0.25%, but there was a split in voting with two members calling for an immediate rise to 0.5%. Following the meeting, the Bank of England dropped heavy hints that they felt that an increase in the cost of borrowing would happen soon, with some commentators suggesting this could be as early as November.
The reasoning behind the shift in position is effectively twofold. Firstly, inflation is above the Bank of England’s 2% target (latest figures for August show that inflation increased to 2.9% from 2.6% in July) and the main monetary policy tool to address inflation is to change the cost of money.
When inflation is low, you seek to stimulate spending activity by reducing interest rates (which makes saving less desirable). When inflation is high, you do the opposite as a way of reducing aggregate demand and spending activity. Furthermore, as our current inflationary pressure is largely driven by the devaluation of the pound, an interest rate rise would also make UK sterling a more attractive currency to hold and so might help boost its value and therefore reduce these pressures.
The second key (and related) factor is the current very high rates of employment, and consequently record low levels of unemployment. Economists have identified a clear empirical historical relationship between unemployment levels and rates of inflation. As unemployment falls, there are fewer people available in the labour market to fill jobs. As a consequence, businesses are forced to increase wages to attract suitable employees, thus leading to what is known as “wage-push” inflation.
The Monetary Policy Committee are therefore looking at the these two key sources of data, and starting to conclude that without action to increase the interest rates, there is a risk that inflation will continue to increase. Given that interest rates are extremely low, and that they will need to increase at some point in the future, there is increasing opinion that a small increase sooner rather than later would be helpful more generally as well, providing a signal of intent to the financial markets that monetary stimulus cannot continue indefinitely, and reducing the potential “shock” of more rapid increases later.
However, the counter argument is that the general economic landscape in the UK is not actually that bright, and any increase in interest rates, however small, would have a significant detrimental effect. Recent PMI (Purchasers Managers Index) data have shown a decline in both service and construction activity between July and August, and real wages continue to fall as inflation outstrips average growth in wages.
The UK had the slowest growing economy of all EU28 countries in the first part of this year and forecasts for annual growth for 2017 and 2018 are being downgraded by most organisations. Much of the slow (and slowing) economic growth in the UK is being attributed to the uncertainty surrounding Brexit, which is impacting upon business investment decisions, and weaker productivity growth. Furthermore, many people are starting to suggest that under-employment is replacing unemployment, with people in low paid, flexible or part-time employment rather than out of work. As such, the relationship between unemployment and inflation may therefore not be as strong as history suggests. Against this backdrop, many economists believe that now is definitely not the time to seek to reduce aggregate demand by increasing interest rates.
The Bank of England is therefore potentially caught between a rock and a hard place. It is likely that inflation will remain high in the short-term while the currency-effects continue to play through in terms of higher import costs; and there is certainly increasing pressure on businesses to increase wages to secure employees in such a tight labour market (and within Warwickshire we are definitely now seeing wage increases coming through). However, the overall economy remains weak and against the backdrop of Brexit uncertainty, it seems overly risky at the moment to increase interest rates.
My own view is that the hinting and signals coming from the Bank of England are more to prevent financial markets becoming complacent about very low interest rates and continuing monetary stimulus. In other words, it is more a reminder that interest could go up (and inevitably will need to increase at some point in the future), than any clear shift in current monetary policy.