Is the Bank of England stuck on interest rates?

Should the Bank of England raise interest rates? The Bank’s rate currently stands at zero and after a slew of positive UK economic data, the question is being asked with increasing insistence in both Westminster and the City.

Unemployment is declining and growth is gathering momentum—the IMF this week upgraded its outlook for British growth to 2.4 per cent and unemployment is in steady decline. In normal circumstances this would give sufficient reason to raise rates, so that the intensity of economic activity would remain under control.

But these are not normal circumstances.

As Mark Carney, the Governor of the Bank of England said at the Bank’s Financial Stability Report press conference in November:

“Despite the return to solid growth, financial stability risks remain, including those arising from high levels of indebtedness both here and abroad.” His remarks then turned to interest rates: “Sharp rises in global interest rates could test financial system resilience, particularly if not associated with strengthening incomes.”

The economy has recovered even further since Carney’s comments, but the essential uncertainty about the status of the recovery and of the quality of the growth still remains. Furthermore, incomes have not strengthened; in something of a puzzle, though growth has returned, productivity has not, meaning that wages have remained stagnant. To repeat—these are not conventional circumstances.

A significant component of Britain’s growth is driven by the housing market. “Housing activity has picked up from a low level and prices are 7 per cent higher than a year ago,” said Carney. “Price increases are gaining momentum and broadening out around the country. Valuations, while below levels reached in 2007, are high by historic standards and are likely to rise in the near term.” In that last comment he has been proved correct.

The status of the housing boom is a sensitive subject for the Government. The Prime Minister’s spokesmen are quick to squash any suggestion that there is a bubble, pointing out that price increases are confined to London and the south east (an argument that ignores the absurd size of the south east’s housing market.) The Government also stresses that the regulatory tools are in place to ensure that any excessive price inflation in housing can be contained.

But such assurances are at odds with the Governor’s analysis. “Risks to financial stability may grow if there are further substantial and rapid increases in house prices and a further build-up of household indebtedness,” said Carney, adding that “these risks would be amplified if underwriting standards on mortgage lending were to weaken as has been the case in previous house price cycles.”

In the wake of these comments, Carney “refocused” the Funding for Lending scheme away from property lending and towards businesses. He also announced that the Financial Conduct Authority, a regulatory division at the Bank of England, was revising its rules on mortgage underwriting standards—all banks and building societies will have to adopt new, more stringent rules on mortgage lending by April.

Such actions and comments do not amount to a vote of confidence in the strength of Britain’s housing and mortgage markets.

Which makes the question of whether interest rates should rise all the more consequential. If the Bank of England raised its policy rate and if mortgage market rates then began to rise, might this affect the housing market in such a way as to bring about the negative consequences for financial stability that the Governor envisions?

In short—would higher rates cause a shock to the housing market that would in turn halt the recovery and place extreme financial stress on households, banks and businesses? And if the answer is yes, then the question is whether Carney will ever be able to raise rates at all—no matter how much growth goes up and employment comes down.