Unshackle the Bank of England – and let rates go up

As far as most observers are concerned, Mark Carney’s speech at the Mansion House last Thursday boiled down to a single half sentence. The first rise in interest rates since July 2007 “could happen sooner than markets currently expect”, the Bank of England Governor uttered, to assembled City grandees and the wider world beyond. This sparked a frenzy of speculation that rates could start rising from their historic low of 0.5pc, where they’ve been since March 2009, sooner rather than later.

Before Thursday, the consensus expressed in bond and currency markets was that the first rate increase in almost seven years would happen early in the second quarter of 2015. Carney’s after-dinner bombshell changed that, with economists scrambling to update their forecasts.

Sterling surged against the dollar and gilt yields rose, as traders adjusted positions to reflect a pre-Christmas rate rise, after the newish Governor, in his first Mansion House missive, warned that households, companies and financial markets must prepare for monetary tightening. The response was significant, with the pound moving just shy of its five-year high against the dollar, the euro conversely dropping to a 19-month low.

For all the headlines and histrionics, Carney’s speech amounted to a great deal more than a single half sentence – and was actually heavily qualified. It was full of the usual analytical discussion relating to estimated spare capacity, for instance, with the Bank pointing to economic “slack” in the system equivalent to 1-1.5pc of national income, suggesting a rate rise won’t come soon.

Straight after his dynamite “could happen sooner” clause, in fact, the Governor explicitly highlighted that “there remains scope for spare capacity to be used up before policy is tightened”, even adding that the Monetary Policy Committee “expects the rate at which slack is being eroded to slow during the second half of the year”. All other things being equal, that pushes the first rate rise further into the future.

Anyone who thinks Carney has just given us a firm indication of what will actually happen should reflect that his much-vaunted “forward guidance” has hardly proved reliable so far. When this guidance policy was launched last August, just ten months ago, the combination of a 7pc unemployment threshold above which the monetary stance would stay put, combined with the Bank’s actual forecasts, indicated that rates would remain at rock bottom for three years or more.

Then, in February, this reassuring certainty crumbled as unemployment fell faster than expected, with the Bank indicating it had switched the focus of its interest to “under-employment” – a slippery concept based on survey data on whether workers want more hours. This subtle change, of course, gave the MPC massive flexibility, fuelling expectations that rates would rise a bit sooner. Three months later, when the Bank’s Inflation Report was published in May, while the core forecasts were barely altered, Carney’s stronger rhetoric was enough to further shift rate-rise expectations to the first half of this year.

The reality is that “forward guidance” has unraveled in the Governor’s hands. And while he insists “the ultimate decision will be data-driven”, very little has changed data-wise since May and yet market expectations have, once again, significantly tightened. The only really crucial news about the real economy over recent weeks is that unemployment fell to 6.6pc during the first three months of this year, a slight improvement on the Bank’s forecast of 6.7pc. This is hardly a major new development and is certainly not enough to warrant the markets moving from a firm view that rates will rise in April 2015 to an equally firm prediction of a hike six months earlier.

While no-one knows when the 9-member MPC will vote to start raising rates, it’s clear that the series of increases we now face, while welcome by savers, will still impose serious pain. Buried in this Mansion House speech, and barely reported, were a number of rather alarming statistics.

The UK’s highly-indebted private sector is “particularly sensitive” to rate rises, said Carney. That’s because private non-financial sector debt is now no less than 163pc of GDP and around two-thirds of bank loans to individuals and more than half of business loans to businesses are at variable rates.

In addition, “there are signs that underwriting standards are becoming more lax”, the Governor reported, with the proportion of new mortgages at aggressive loan-to-income ratios now at an all-time high. Around 40pc home loans extended in recent years have loan-to-income multiples of at least 3.5, the speech footnotes disclose, with a quarter at 4-times or more and a tenth at 4.5. This is shocking.

Carney also didn’t spare the government’s blushes when he pointed to the “chronic shortage of housing supply, which the Bank of England can’t tackle directly”. It’s clear the Governor is worried the housing market is in danger of over-heating, which could bring a dangerous crash. While showing signs of slowing, prices are still 14pc higher year-on-year, even if the surge is predominantly focused on London and the South-East.

While George Osborne has taken some steps to rein-in the market and did more on Thursday, giving the Bank powers to cap mortgage lending, these measures won’t apply for at least a year – in other words, not until well after the general election. With his dangerous Help-to-Buy scheme still in full swing, the Chancellor still has one foot very firmly on the housing market accelerator, even if the other is now hovering over the brake.
Carney is right to keep publicly highlighting his housing market concerns. He was also right to include in the speech – if, again, relegated to a footnote – Kate Barker’s estimate that the UK needs to build 260,000 homes a year to keep house prices under control, compared to last year’s paltry total of just 110,000.

My own view is that the MPC now needs to stop pussy-footing around and just get on with it. There are signs of that happening. When the minutes of the latest MPC meeting are published next week, we may learn that at least one member has already broken ranks and voted for a hike. If that’s true, then others will quickly follow. It may be that Carney’s Mansion House half-sentence was a nod to that development, with the Governor wanting to be seen leading opinion on the committee, not following in its wake.

The UK no longer requires emergency measures – and hasn’t for several years. The record 345,000 employment increase over the three months to April makes that clear. The economy is now expanding at an annualized rate of no less than 4pc, as Carney himself pointed-out. It can’t be assumed, either, than price pressures won’t return. CPI inflation jumped upward in April, from 1.6pc to 1.8pc, the first increase in 10 months. Oil prices, rising steadily even before this latest bad news from Iraq, are now at a 9-month high.

Amidst all this uncertainty, though, two things seem clear. The first is that the Bank’s insistence that rates will peak at 3pc, rather than 5-6pc as in recent cycles, is far-fetched. Why should the rate cycle be narrower? After all, there’s now far more debt around than in previous upswings, suggesting higher borrowing costs.

What also seems obvious is that if we don’t increase rates “ahead of the curve”, then they’ll eventually have to go up further than they otherwise would – resulting in far more pain for debt-soaked firms and households. That’s why the government should unshackle the Bank, put an end to this vacuous speculation and let rates rise.