The UK economy faces a few paradoxes.
Low Growth – High Inflation. Firstly, after a deep recession the economic recovery is weak. In theory, high unemployment and low growth should lead to low inflation. However, due to rising energy and food prices, we have inflation above target. This presents a conundrum for the Bank of England – do they increase interest rates to reduce inflation or do they keep interest rates low to boost spending and help reduce unemployment?
High Unemployment – Yet tight Fiscal Policy and tight Monetary Policy. Usually at this stage in the economic cycle, you wouldn’t want a tightening of fiscal policy and monetary policy at the same time. It could cause the recovery to stagnate. Yet, this is the prospect we face. Tight fiscal policy and increasing interest rates.
Negative Real Interest Rates. We often talk about ‘normal’ interest rates. What this implies is an interest rate above the rate of inflation. This means savers should be able to get an increase in the value of their savings. A negative real interest rate means the value of savings is decreasing. At the moment, Bank of England, base interest rates are significantly below the CPI, therefore, in theory, savers are losing out.
This is mitigated by the fact banks are trying hard to attract deposits, therefore there are saving accounts which still offer positive real interest rates. But, in medium term, the Bank will want a return to ‘normal’ interest rates. This means, we could see base rates shoot up to 5%.
Fear Ultra Low Interest Rates may stoke Future speculative Bubble. The recent financial crisis was caused by excessive borrowing and speculation. The danger is that ultra low interest rates could stoke a future boom and bust in lending. That is a possibility, though banks are trying hard to increase bank reserve ratios. For example, mortgage lending remains restricted.
Where does that leave interest rates for 2012?
Some forecast a speedy return to 5% at the end of the year. (Recently, Bank of England Markets Director Paul Fisher warned interest rates could rise to 5% soon). They see signs of economic recovery and to keep inflation in check we need a return to normal interest rates. That might sound a huge jump, though the impact may be muted because many banks didn’t pass on the interest rate cut on to consumers.
However, others argue there is danger of stagnating growth. Higher taxes and spending cuts will reduce growth. Given high unemployment, we need monetary policy to be loose to offset the fall in government spending. Also, though CPI inflation is slightly above target, it is has not led to wage inflation and CPI inflation may fall back, if energy prices stop rising.
Overall, there is strong likelihood interest rates will rise in 2012. The big question is how early and how quickly. This will depend on the pace of economic growth and the stubbornness of inflation.