After 5 long years of keeping interest rates down at 0.5%, people are increasingly expecting the Bank of England to raise its Bank Rate as the economy recovers.
05 Sep 2014
Exactly when the Monetary Policy Committee decides to put rates up is uncertain. Unemployment is falling fast, suggesting that the economy is heading back to normal. But wage growth is very subdued and inflation below the 2% target, meaning the MPC is in no rush to raise rates. Most commentators think rates will rise in the first 3 months of 2015, but there are no guarantees: there’s still a 1 in 4 chance that rates will be on hold this time next year.
With interest rates having been kept so low for so long the intense focus on when exactly the first rise will arrive is understandable. But it misses two much more important points.
The pace at which the Bank of England decides to put rates up is critical. A series of sharp rises in quick succession would undoubtedly sap demand and weaken growth. Just as it did in 1988 when the base rate went up 5.5% in 6 months. But that’s not what the MPC is planning to do. Its guidance is that it expects rate rises to be gradual. There are no promises, if inflation took off the Bank of England might be forced into putting rates up faster than it would like to. But if the recovery develops as it expects the MPC’s preference would be for rates to rise at a pace of 1% per year or slower.
The second important point is that even when growth is back to normal and unemployment has fallen even further, interest rates might still be a long way from what we used to describe as normal. Bank Rate averaged 5% in the 10 years before the crisis, but the MPC has pointed to factors that suggest rates could be “materially below” 5%, even when the economy is growing normally. One such factor is fiscal austerity. Based on the Government’s latest estimates it will take another 5 years to close the deficit, meaning demand in the economy will be held back as the public sector continues to cut back. To counter this, the MPC thinks it will need to keep interest rates lower than it used to.
Talking about what might happen to interest rates in the future is new to the Bank of England. It is part of the policy of forward guidance that was initiated shortly after Mark Carney arrived as the new Governor. There’s a delicate trade-off here. The MPC is trying to help individuals and businesses understand its intentions in a complicated world. But the economy is unpredictable and experience shows that things can turn out much better, or much worse, than even the most detailed forecasts. The MPC’s guidance can therefore be thought of as only being valid in a world where the economy develops as its forecasts predict.
So what should business-people do in the face of this uncertainty?
The key is to understand what matters for your business. What would your finances look like if interest rates rose by 1% between now and the end of 2015? Would they be robust enough to cope with a 2% rise? Would these costs drive you to change your prices or could you make savings elsewhere? Are there ways to make your working capital more efficient?
Every business is different, there’s no one-size-fits-all solution. But talking to your Bank’s relationship manager can help you explore the options and see what is right for your situation, whatever the UK economy throws at you.
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