Bank of England indicates rise in interest rates

17th July 2015

Mark Carney, Governor of the Bank of England, spoke at Lincoln Cathedral last night providing the strongest indication to date that interest rates could rise at the turn of the new year. Robert Moore attended the lecture and shares some of the main points Governor Carney raised during his major monetary policy speech.

 

Currently sitting at 0.5pc point, a record low at which it has been kept for the last six years, there is a need for the base rate to rise to reflect the momentum in the economy

 

Inflation, targeted to be at 2pc, is a far increase from the current flat line of 0pc. The main reason for the current below target figure is explained by the steep fall in the prices of commodities and other imported goods since last year. Single most important factor is the steep drop in energy prices globally. Rise in the value of sterling has also played an important role in lowering non-energy import prices. It is estimated that these issues alone have contributed to a 1.5pc point reduction below the target figure.

 

This temporary period of below target inflation has provided welcome boost to real household income.

 

Monetary Policy Committees intention is to return inflation to 2pc within two years, and therefore the base rate will need to adjust to remove the slack in economy to trigger sustained increase in costs necessary to achieve inflation target.

 

The timing of a rise in bank base rate will be dependant of many factors. A couple of issues which were discussed during the evening were;

 

1. Momentum in economic activity – sustainable growth at a level above the past average of 0.6pc per quarter needs to be achieved.

 

• Governor Carney believes things look positive. The economy has been growing above trend for a year and unemployment has fallen sharply over the past two. Consumer confidence is at its highest level for over a decade. Business investment intentions are solid, and momentum in the exchange of housing stock is showing signs of returning.

 

• International risks to growth outlook remain. Situation in Greece is actively fluid, but forecasting ahead, the on-going slowdown in China could be more significant.

 

• On balance we can expect the global economy to proceed at a solid – but not spectacular pace.

 

2. Domestic Costs – need to continue to firm.

 

• Wage growth has been weak, but is improving. The tightening of the labour market is resulting in further positive wage developments. Job to job flows remain around post crisis highs and vacancies to unemployment ratio is now back to pre-crisis average.

 

• Wage Growth can’t be looked at in isolation but relative to productivity – the efficiency of the work force. Governor Carney stated that in order to return inflation to target, growth in labour costs must increase from their current rate of less than 1pc. To put this in context, prior to the crisis, labour costs grew by around 2.5pc per year on average, with wages and salaries growing at around 4.75pc and productivity at around 2.25pc. Inflation during this period averaged the now target of 2pc.

 

Governor Carney predicts that it would not seem unreasonable to expect that once normalisation begins, base rate increases would proceed slowly and rise to a level in the medium term that is about half as high as historical averages, making reference to 4.5pc average since the Banks inception 3 centuries ago, thus indicating a slow increase to 2.25pc, over the next 3 year period.

 

With a prediction that a move upwards in base rate will commence at the turn of the year, some cautionary notes were provided;

 

• Shocks in the economy could easily delay, adjust and effect the timing and magnitude of the interest rate increases.

 

• There is great sensitivity attached to UK household balance sheets – something highly relevant in our still heavily indebted post crisis economy.

 

• UK mortgagors will be affected, with over half predicted to pay higher rates in a year’s time and 75pc in two years’ time, should interest rates evolve according to predictions. Mr Carney told the audience that UK interest rates were expected to rise at around half the pace of the US, partly because British households are more exposed to the impact of higher rates.

 

Hosted in a spectacular gothic setting and as part of a series of lectures celebrating the 800th anniversary of the Magna Carter, Governor Carney delivered his clearest indication yet that the UK economy is slowly regaining confidence and that looking forward the monetary environment is about to change.

 

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