Bank of England base interest rates are currently 0.5%. Economists are divided about when interest rates will rise. Some point to the evidence of a strong economic recovery to suggest interest rates could rise by mid 2015. Others argue that the strong global deflationary pressures mean that UK inflation is likely to stay very low (currently 0.5%) and therefore interest rates will stay at 0.5% until even 2016.
When interest rates were cut to 0.5% in 2009, few would have predicted that interest rates would have stayed so low for so long. In the past few years, expectations of rising interest rates have often proved a false dawn. The reasons for a rise in rates have later evaporated. Will 2015 be a similar experience with the long-awaited rise in interest rates delayed again?
Projections for interest rates (Nov 2014)
- 2015 – 0.8%
- 2016 – 1.4%
- 2017 – 1.7%
The Bank of England inflation forecast from Nov 2014, suggests inflation is expected to continue to fall until 2017. They see no immediate rise in inflation.
Latest Bank of England forecast Nov 2014
However since the latest Bank of England inflation report in Nov 2014, inflation has fallen more sharply than expected, and this could delay the time of rising interest rates.
Why are interest rates likely to stay at 0.5% until 2016?
1. Falling inflation
Inflation has fallen to its lowest level since 2009. Part of this is due to falling energy prices (oil and gas and other commodities). This volatile factor may not last, but many oil analysts expect prices to keep dropping as Middle East countries are happy to keep supply high. This will continue to depress inflation and could lead to lower price expectations in the whole economy.
However, apart from oil prices, it appears underlying inflationary pressures are still low. There is intense competition in retail / supermarkets – consumers have come to expect low prices – it is reminiscent of Japan’s decade of deflation.
Graph showing wage growth. Since recession, nominal wage growth has consistently been lower than inflation.
A key factor in determining future inflation and interest rates will be nominal wage growth. A feature of the recovery so far has been that wage growth has been very low. This is important for underlying inflationary pressures – wages affect the cost of firms (cost-push inflation), and also the income of workers (demand-pull inflation). Whilst wage growth is very low, there is a strong case for keeping interest rates low. However, towards the end of 2014, we see the first sign of increasing wages. The MPC will be looking very closely at the next wage statistics and evidence of tightening in the labour market (will unemployment continue to fall?), as soon as wage growth becomes steadier, we can expect rising interest rates. But, with prices plummeting, it may prove difficult for workers to gain wage increases.
Europe and deflationary pressure
Our main trading partner, Europe, is experiencing outright deflation. This will impact the UK economy through – lower confidence, lower inflation expectations, and greater price competitiveness. If Europe is experiencing deflation, it will affect the UK economy and UK inflation. The concern is that Europe may imitate the recent history of Japan – where inflation and interest rates stayed low for a considerable time period.
Housing market to turn?
One concern about keeping interest rates at 0.5% is that it has fuelled a mini housing boom, especially in London and the South East, where prices have risen rapidly. Some argue that higher interest rates are needed to prevent rising house prices. But, some forecast the London housing market may now turn – a lack of buyers at the high prices could lead to falling prices. This would take off one pressure to raise rates.
Economic growth to falter?
The strongest case for rising interest rates is the consistent economic growth since early 2013. With economic growth running close to the long run trend rate of 2-3%, this creates a strong reason to raise rates back to more normal levels. If this growth continues, it may prove hard for the MPC to keep interest rates at 0.5% However, with Europe stagnating, there is a danger that the UK recovery could falter – because it is too unbalanced and reliant on consumer spending.
The interesting thing over the past few years is how frequently forecasts of rising interest rates have proved not to occur. It seems at the start of every year, some analysts make reasonable assumptions that interest rates are likely to rise in the next 6-12 months, but the reasons for these interest rate rises keep evaporating. At the moment, we face an interesting set of circumstances – good economic growth, but inflation tumbling. The big question is will the UK follow Europe into deflation (or at least very low inflation) or will the recovery lead to rising wages and a return to normal interest rates?
Theory of setting interest rates
The MPC are responsible for setting interest rates. Their main target is low inflation. – CPI inflation of 2% +/- 1. They also take into account other objectives such as economic growth. Often it is a balance between keeping inflation low and maintaining sustainable economic growth.
In setting interest rates, the MPC will consider various economic statistics which give an indication of inflationary pressure in the economy. These will include:
- Economic growth / compared to the long run trend rate. If growth is above the long run trend rate (2.5%) then it is likely that inflationary pressures will increase and interest rates tend to rise. Lower economic growth will encourage interest rates to be cut.
- Wages. Higher wages will feed through into both cost push and demand pull inflation.
- Cost push inflation. e.g. rising oil prices could cause inflation and encourage the MPC to raise interest rates. However, the MPC may choose to ignore cost-push inflation because it is likely to be temporary
- Exchange Rate. A depreciating currency will increase inflation because of cheaper exports and more expensive imports. A Central Bank may decide to increase interest rates to protect the value of the currency too.