As you can see from the graph above, UK interest rates have flatlined at 0.5% since the recession took full effect in 2009. At the time, economic activity was low, unemployment was rising and banks didn’t want to lend money to anyone. An interest rate cut was needed, and this is exactly what happened (although much later than I anticipated).
It is true that the economy is suffering from unemployment and reduced consumer confidence even now, which is why budget cuts and tax rises are arguably not helping matters. This is likely to be the reason that the Bank of England, up until now, have decided to keep interest rates at the lowly 0.5% for well over a year.
I was planning to predict an interest rate rise sometime this year and I might have sounded a little smarter if I wrote this article when I intended to in January! Now, it seems that people are all but certain that rates will go up at some point this year. Why is this?
Ahh yes, inflation. The magic word in monetary policy. The retail price index measure of inflation was announced as being at 5.5% p.a. and the consumer price index was announced as being at 4.4% p.a today. That is some way over the 2% target set by the government.
Food prices have been noticeably higher in recent months, but so have many other regular items of expenditure – from fuel to clothing.
This seems to confirm the fact that the original Phillips Curve relationship, which stated that there was a trade-off between unemployment and inflation, was really a phenomenon of the past (or a short run effect at best). This was also evident in the boom phase of the early 2000s, which saw low inflation and low unemployment – the polar opposite of what we are experiencing now.
According to the Taylor rule of monetary policy and the Fisher equation, optimal policy suggests a rise in interest rates higher than the increase in inflation is necessary to bring the real interest rate down, creating disinflationary pressure. So why have the Monetary Policy Committee been so cautious to raise interest rates?
The obvious concern is the fact that the economy is still suffering the effects of the recession – possibly more so now in the so called ‘recovery’ phase. The risk is that with higher interest rates, it will put an even tighter squeeze on already suffering households by increasing lean and mortgage repayments and hence discouraging consumption. With the recent announcement that consumer confidence has fallen, raising interest rates is certainly risky.
Expectations and Credibility
Something that may go unnoticed by the average person is that monetary policy can actually happen just because people expect the Bank of England to do something. Because it is well known that they have a duty to maintain a 2% target level of inflation, when inflation gets high, people expect interest rates to go up. When this happens, they start adjusting their behaviour before anything actually happens.
A good indicator for what people expect to happen with interest rates is the yield curve for government bonds. The yield curve above shows that there are higher yields for longer term bonds. In other words, this means that people expect interest rates to increase over time. If you flipped the graph vertically, it would imply lower interest rates in future. This is known as an ‘inverted yield curve’.
The fact that people expect interest rates to increase may mean that they start saving more now, that banks increase saving and borrowing rates, that investment begins to fall and so on. This means that the Bank need not actually do anything to achieve (partially at least) the results that they want.
Great right? Well, if the Bank decides to do nothing after all, they will begin to lose credibility. This would be a very bad thing. Increased uncertainty increases risk for firms, banks and individuals and this can do horrible things to the economy. We certainly don’t want to go back to the situation in the recession where everyone was left cowering in the corner – nobody was lending and nobody was spending.
To maintain face and faith, I’m confident that the Bank will have to interest rates at some point this year (I was confident of this in January, and I’m even more so now). The question is ‘by how much?’
It’s definitely a delicate decision, and one that somewhat justifies the cautious approach that has been taken. However, I think interest rates have been somewhat ‘undervalued’ and so I’d expect them to be at least at 1% by the end of 2011, if not higher.
If that happens, remember, you heard it here!
If not, I’ll be whistling innocently in the corner somewhere far away…