If you believe that interest rates are going to rise quickly, think again
Financial markets are calculating that the Bank of England is going to be rather active in 2022. Investors now expect the Bank’s Monetary Policy Committee (MPC) – the group of policymakers responsible for guiding interest rates – to increase the headline UK interest rate from its historic low of 0.1%. Traders with ‘skin in the game’ on these decisions – a pure form of market expectations – now expect that the UK interest rate will be closer to 1% a year from now.
Whilst older Times readers may scoff at such low levels having lived through periods when interest rates far exceeded 10%, the reality is that moves of this magnitude would be the fastest changes to interest rate in 15 years. There is a whole generation of borrowers, and indeed savers, for whom this would be a wholly novel backdrop to their financial decision-making. Coming off the back of an enormously disruptive period for the world economy, and for society, I think it is unlikely to happen. In short, I believe the markets are wrongly positioned.
It is no secret that the UK economy faces a tough winter. The old foe of economic performance – inflation – is making for nervous investors, businesses and consumers. The rate of increase in UK prices is already well above the Bank’s target of 2% a year. UK inflation is expected to remain at more than 4% until the middle of 2022 – perhaps even longer if energy costs remain at their current eyewatering levels. For an inflation-targeting central bank like the Bank of England this is a tricky problem.
For some observers any interest rate increase in the UK already risks being too little, too late. The cost of getting inflation back under control, at least historically, has been so high that many economists believe pre-emptive action was necessary over the summer. Ex Bank of England Chief Economist Andy Haldane was in that camp. Existing MPC members Dave Ramsden and Michael Saunders have recently joined it. For others, however, such a move remains unwarranted with many of the reasons for the current high inflation rate little-influenced by UK monetary policy. Indeed, it seems unlikely that higher UK interest rates will impact shipping costs out of China, gas supply from Russia or the availability of chefs in Cornwall. The only certainty when the Monetary Policy Committee meet early in November is that the debate will be lively.
For readers wondering who to listen to on interest rates, I would suggest a reliable rule of avoiding those who sound too sure. It is simply impossible to have a once-in-a-century recession, a record rebound in employment, unprecedented government spending and erratic inflation – all against the backdrop of a novel global pandemic – and yet be certain what happens next. This does not mean, however, that businesses and households cannot plan. They can. They can plan – hopefully reassuringly – on the assumption that interest rates are going to change gradually, not dramatically. There are too many contradictory data points for this generation of central bankers – acutely aware of policy mistakes of the recent past – to move quickly and aggressively.
My own view is that with considerable cost-of-living challenges facing UK households – including rising energy bills, the end of mortgage and rent forbearance, the end of both the £20/week Universal Credit uplift and furlough scheme – the advantage gained by waiting until the early Spring outweighs the risks. Recently published research by economists David Blanchflower, formerly of the MPC, and Alex Bryson suggest that a recent pullback in consumer confidence seen in the US, and now emerging in the UK data, is a reliable predictor of a forthcoming recession. Whilst I do not agree – with household and business balance sheets remaining strong – the value in waiting a few more months to see the impact of withdrawing emergency economic support would appear sensible.
There is also another important factor that means that the Bank of England is unlikely to move fast on its policy interest rate. The central banks of the United States, of the Eurozone and in Japan have no plans to raise their own interest rates throughout 2022. Central bankers are pack animals – they rarely deviate from each other. At least not by very much. Whilst critics of this complacency amongst the world’s major central banks may point to the current spike in inflation, most of these central banks have had to grapple with below-target inflation in recent years. Over the last decade inflation has averaged 1.8% in the UK, 1.6% in the US, 1.2% in the Eurozone and just 0.5% in Japan.
One of the reasons the Bank of England has found itself in under more pressure than most of its contemporaries is that the Governor, Andrew Bailey, has delivered a rather disjointed communications message in recent months. There have even been suggestions that the actions of the Bank were designed to directly finance the UK government’s debt. These were comments that the Governor later clarified. Even so, this is a red line for independent central banks and any suggestion of what is known as ‘monetary financing’ calls into question the credibility of the Bank of England. Credibility is much like a bank account – spend too much of it and it runs out. One of the arguments being made in the UK why an early interest rate increase is needed is to show it has credibility in fighting inflation. That argument would be far weaker had the message been clearer around why the Bank continued to buy more than £400bn of government debt throughout the pandemic.
I am not alone in suggesting this is the most complex time for setting interest rates in the last quarter of a century. That period includes the Global Financial Crisis. The economic backdrop, however, means any policy changes are likely to be gradual, rather than dramatic. That is good news. Those who like boredom back in their financial lives must be hoping the Bank’s policymakers are listening.
Managing Director, Chief Economist