The UK’s level of inflation is officially 0%. Two days ago, government statistics revealed unemployment rose in June for the first time in two years. British households have record levels of debt relative to income, and the global recovery looks increasingly fragile as China’s growth slows. It seems an odd juncture for the Bank of England governor to talk about raising interest rates.
In a speech at Lincoln’s gothic cathedral last night, Mark Carney spoke at length about Magna Carta and 12th century money supply (no, really), before seguing to the Monetary Policy Committee’s (MPC’s) need to raise the Bank Rate, which ultimately determines commercial lending rates.
‘In my view, the decision as to when to start such a process of adjustment will likely come into sharper relief around the turn of this year,’ said Carney, adding that it ‘reflects the momentum in the economy and a gradual firming of underlying inflationary pressures.’
It’s not as odd as it sounds. For a start, the UK’s current zero inflation is deceptive, reflecting the fall in oil and commodity prices, and the strength of Sterling making imports cheaper. Together, Carney said, these factors pulled inflation 1.5% below its 2% target, but in a few months the effect of cheap energy will fade.
MPC rate changes take up to 18 months to take effect, so what Carney is really saying is that he expects inflation to rise next year. When the rates go up – presumably at the end of 2015 or early 2016 – it will be largely pre-emptive.
Think of the economy as soup (cream of asparagus). You want it to simmer nicely, but you don’t want it to boil and ruin the flavour. During the recession, the soup got cold, so for six years we’ve had the gas on full. Chef Carney wants to turn it down before it starts to boil, not after.
The reason he suspects it will start to boil over with price inflation is that wages are rising with economic growth, which should translate to higher consumer spending.
Whenever the rise begins, it will be both gradual and gentle. Carney said interest rates should increase from 0.5% now to roughly 2.5% in about three years’ time, possibly in super-small quarter point increments.
That’s a broad intention rather than a defined plan of course. ‘Shocks to the economy and shifts in the exchange rate, for example, could easily adjust the timing and magnitude of interest rate increases,’ Carney said.
This is perhaps the point. Although interest rate rises aren’t good for businesses (other than banks, of course), deterring investment, increasing debt repayments and hitting exporters by strengthening the pound, they are necessary for the country’s long term economic stability.
Cheap money is addictive. If central banks like Britain’s or America’s (Fed chief Janet Yellen is expected to raise rates there this year) don’t wean themselves off it, they won’t be able to respond sufficiently when the next crash or shock happens. As such, the gradual, tentative rise Carney suggests will be welcome.
Don't expect anything before Yellen makes her move though. Britain has followed the American monetary policy lead since the crisis and - although rates will probably rise higher in the US where exposure of mortgages to short term rate changes isn't anything like so high as it is here - it is unlikely to deviate too far now.