Rates could rise sooner than anticipated

Bank of England Governor Mark Carney has hinted that interest rates could rise sooner than expected and perhaps by the end of this year, although any changes would be very small and incremental.

Speaking at Lincoln Cathedral last week, Mr Carney said he expected rates to rise over the next three years, reaching “about half as high as historical averages” or around 2%. Interest rates have now been at their historic low of 0.5% for over six years as the economy has gradually recovered from the financial crisis.

The Governor added that the Monetary Policy Committee (MPC), which sets the rate, would have to “feel its way as it goes” but expects that once “normalisation” begins, interest rate increases would proceed slowly.

As far as timing is concerned, Mr Carney said the decision as to when to start such a process of adjustment would “likely come into sharper relief around the turn of this year”. As he pointed out, the rate of CPI inflation is currently zero but, as the effects of lower oil prices lessen on a year-on-year comparison, the CPI is expected to pick up after only a very short period in which it turned negative. In other words, Deflation was – in the words of Conan Doyle in the “Silver Blaze” mystery – “the dog that didn’t bark”.

However, although inflation is expected to pick up only gradually this year, Governor Carney stressed that the time for the MPC to act was getting closer, as any action by the Bank would take around 18 months to take effect.

His comments were underlined by the latest data for average earnings, which indicated that wages and salaries including bonuses increased by 3.2% on a year earlier compared with the CPI increase of 0%. Unemployment is now 5.6% (some 1.4 percentage points lower than the 7% that the Bank of England had indicated would be its “Forward Guidance” for starting to increase interest rates) and skills and labour in some sectors are in very short supply.

In other words the concern is that accelerating growth in real earnings could begin to stimulate consumer spending too rapidly to be sustainable, all spare capacity would be used up and household debt levels would start to pick up fast. These developments would in turn cause inflation to accelerate and push the CPI above target over the next 2-3 years.

So a higher Bank base rate sooner rather than later would dampen any risky rise in household borrowing and ensure that the recovery in consumer spending and the housing market was sustainable. By keeping consumer spending growth under control, it might also prevent a further widening of the trade deficit, which has started to worry policy makers on the Financial Stability side of the Bank – although, at the same time, expectations about rising interest rates would also tend to push up sterling and make life more difficult for exporters.

The MPC will also want to be careful not to push up rates too fast in case this puts at risk the UK’s recovery in business investment, which will remain fragile while global events (including the Greek crisis) are still volatile.

So the MPC has to find a balanced path through a number of potentially conflicting objectives – hence Governor Carney’s caution about not raising rates too fast or too high.

What is clear however is that, for savers, who have been suffering from shrinking returns for years, not much relief is in sight!

Posted in Blog, Economy.