Reflections on UK interest rates

Following Governor Carney’s speech last week, it’s now reasonable to expect that the Bank of England MPC may begin its tightening cycle this November as against previous expectations of February 2015. But it’d still be right to anticipate that the tightening cycle will be gradual and limited, and we can look for rates at 1.5% at the end of 2015 and 2.5% at the end of 2016.

The economic picture suggest that the risks of the MPC going sooner than expected – say, in August – are greater than them tightening faster than expected with the Governor’s Mansion House speech signaling that broad-based policy tightening in monetary and macro-prudential policy is imminent. His suggestion that policy rates could rise this year (“the first rate hike … could happen sooner than markets currently expect”) was explicit. Although this did show a shift in terms of timing, we do not think it contradicts the “phase 2” forward guidance that the Bank introduced in February.

But, in theory, a gradual tightening path with a low terminal rate should be consistent with policy tightening starting earlier rather than later. In his speech, Carney seemed comfortable with markets pricing in the prospect of a terminal rate of 2¼% despite his comment on the timing of the first hike. So this change in tone is more about when the Bank starts its journey rather than its intended destination.

In effect, the reasons for the change in tone are the economy and the changing nature of the risks it poses. The two key factors are, in our view, first, very strong, yet stable growth that is rapidly reducing the amount of spare capacity in the economy and a highly leveraged household sector sensitive to Bank Rate.

The first point raises the risk that policy remains too loose for too long and requires a more aggressive monetary response later on; the second point suggests that if such an outcome were to occur, the economic and financial damage could be considerable. As such, tightening can be presented and implemented as “insurance” against economic and financial instability, supporting expectations of a slow and limited tightening cycle, and one in which tighter macro-prudential and monetary policy moves complement each other.

Before the speech, financial markets had showed unusually little response to persistently strong UK data. Given that the risk of rising rates has now been raised, the opposite may be true. And given the momentum of the UK economy, such economic data should prove strong for some time yet.

There are two key features of the UK economy that will determine the timing and pace of policy tightening, in our view.

The first is strong, yet stable growth that is rapidly reducing the amount of spare capacity in the economy with evidence across a range of economic indicators and surveys and especially the labour market with the pick up in total hours worked, which in the three months to April, hit its strongest pace since the late 1980s. Strong labour demand is leading to a rapid tightening in labour market conditions with unemployment falling rapidly and other indicators are consistent with it falling below 6% in the next 4-6 months. The unemployment rate is still above its pre-recession average, but the working age employment ratio is higher than it was on average in 2000-07 and it is rising fast.

It is true that the combination of economic strength and labour market tightness has not as yet generated much wage inflation, but nominal income growth for the economy as a whole is strong. Joining the dots, year-on-year nominal GDP growth in Q2 could be over 6%, in line with its growth rate before the crisis, and the current weakness of wages looks consistent with labour capturing only a limited amount of that growth at present. But given the direction, momentum and level of labour market indicators, that may not remain the case for long.

The rate at which the spare capacity is being absorbed suggests that some on the MPC may be concerned about the risks of maintaining the current expansive policy settings for much longer. The Bank has frequently stated the need to balance the risk of raising rates too early, when there is no capacity to cut them significantly against the risk of raising them too late, when a more significant adjustment may then be required.

Current data are consistent with a shift in the balance of those risks, and the consequences of the latter risk are significant given as Governor Carney noted in his speech, that “the highly indebted private sector is particularly sensitive to interest rates”. To put numbers to this, a rise in rates to 4% would deliver a powerfully negative shock to households that would likely generate economic instability through much weaker consumer spending, and financial instability in that it would raise the risks of losses on banks’ mortgage loan books.

Given the economic backdrop and this risk, Carney’s speech suggests that the MPC is coalescing around the judgement that it may be more prudent to begin tightening sooner and aim for a slow and limited tightening cycle rather than risk being forced to respond rapidly later. That was also suggested by Carney’s apparent validation of the market’s pricing of a terminal rate of 2¼%.

There must be a risk that the Committee coalesces around that decision quite quickly, especially if there are continued strong data – and a further indication that the strength of the economy has changed the tone of the policy debate was Mr Carney’s suggestion that macro-prudential measures and monetary tightening should be complementary. That’s a change from  his December speech, where he suggested that the economic environment meant that they could be seen as potential substitutes.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla