A rise in rates once meant that the economy was returning to normal health, but not this timeby Duncan Weldon / October 26, 2017 / Leave a comment
Rarely has an interest rate rise in the UK been as well flagged as the one expected next week. Over the past few months, Bank of England reports, speeches from Monetary Policy Members and interviews from the Governor have all played up the fact that rates will rise “soon.” Next Thursday the crescendo will end either with the first hike in more than a decade or with Mark Carney cementing his reputation as an “unreliable boyfriend” who can’t be trusted on the path of rates. With the markets pricing in around an 85 per cent chance of a hike and with so much credibility staked on the decision, it is hard to see the Bank backing down now.
Of course, although journalistic convention demands that any increase in the Bank’s base rate is called a “hike,” it’s important to remember that what the Bank will likely do next week is take the level of rates from the historically low 0.25 per cent they reached last August back to the still historically low level of 0.5 per cent which prevailed for the eight years before. UK monetary policy is still set to be ultra-easy next week, just a little less easy than it was.
Although inflation is high and unemployment low, growth is fairly tepid, real incomes are being squeezed and Brexit-related uncertainty is putting a dampener on business investment decisions. Now hardly seems like an ideal time to start tightening policy. Indeed, until only a few months ago financial markets expected no increase from the Bank before 2019. This raises two questions—what changed? And is this just a lone hike or the start of a cycle? The answers look to be related.
To answer both, the important point to grasp is that the Bank is not being driven into hiking by a renewed sense of confidence in the UK economic outlook. Indeed its most recent forecasts show growth plodding along around the 1.6 to 1.7 per cent mark for the next two years against a pre-crisis average of almost 3 per cent. If anything the Bank has become more pessimistic on the medium term outlook at the same time as loudly signalling that it feels the need to tighten policy.
“The Bank is not being driven into hiking by a renewed sense of confidence in the economic outlook”
This is unusual. Ever since rates hit the floor in March 2009 it has been reasonable to expect that an increase would be good news. It would represent a more upbeat economic performance. The hope was that as the economy returned to “normal” then so would rates. The impending rise though doesn’t elicit the same warm feeling about the UK’s economic health. Quite the opposite.
This is a hike driven by pessimism not optimism, by despair rather than hope.
The majority of the Monetary Policy Committee appear to have become distinctly downbeat about the UK’s medium term prospects. For a decade British productivity (the ability to get more economic output from the same inputs) has been essentially stagnant. Growth has been driven not by getting more out of existing resources but by using up spare capacity, hence unemployment falling to 40 year lows and employment levels hitting records despite an historically weak recovery.
The problem with that sort of growth model is that, eventually, an economy will run out of idle resources to use. In economic parlance, the “output gap” will be closed and an economy will start to run over capacity. As demand rises are not matched by rises in supply then price pressures will rise and inflation start to pick up. The response of an inflation targeting central bank, like the Bank of England, is straight forward: tighten policy.
Has the Bank “truly joined the ranks of the productivity-pessimists”?
The majority of Bank policy-makers now appear to think the UK has reached this point. For what it’s worth, that’s debatable—yes unemployment is low, but under-employment looks to be high and with wage growth still weak, the labour market may not be as tight as it appears. Regardless though, what matters now for policy is how the MPC perceive the UK economy to be not how it actually is.
The big outstanding issue is whether next week’s tightening is a “one and done” hike, simply reversing last August’s cut or whether it represents the start of a gradual cycle of hikes. Bank watchers will be looking for clues next week in the new Inflation Report and at the Governor’s press conference but if the Bank truly has joined the ranks of the productivity-pessimists, then it is hard to see the case for “one and done.” Instead the Bank may have the difficult of task of communicating that yes rates are going to keep going up, but the pace will be slow and the end point much lower than in the past.
Whereas once a rise in interest rates could have been taken as signal that the economy was finally returning to normal, what is likely to happen next week is the other way around. A rise in interest rates will signal that the bank thinks that what we have now is the new normal. In its view the sluggish growth of the past few years may be about as good as it gets.