Changed Expectations On Interest Rates Are Welcome

Having reduced interest rates over the summer, the Bank of England last week confirmed it’s no longer planning to cut again. That’s a good call, not least because the original shift down was anyway a mistake.

After rates were reduced from 0.5pc to a record low of 0.25pc in August, following the UK’s referendum to leave the European Union, Bank Governor Mark Carney indicated they could fall even further. The Monetary Policy Committee now admits the UK economy is significantly stronger than it had expected in the wake of the Brexit referendum. Ergo, such “forward guidance” of even lower rates has expired.

The August rate cut was unnecessary, in my view, and probably counter-productive, as I said at the time. Almost six weeks on from the referendum, amidst buoyant retail sales and continued strong hiring, it was already clear the Brex-a-geddon post-referendum meltdown that the Treasury, the Bank of England and numerous others had loudly predicted if we voted Leave, wasn’t going to happen.

A quarter-point cut does little to boost growth when rates are already at rock-bottom, only 30pc of UK households have a mortgage and over half of those are anyway on fixed rates. And cutting rates at that time, while sterling had already been falling and financial markets were jittery, could have provoked a panic.

Be that as it may, it’s a good thing the Bank has now shifted expectations, indicating that the next time rates do move, it will probably be up. The notion that UK interest rates have been far too low for too long has, for many years, been a consistent theme of this column. I’m glad the consensus is finally starting to switch.

One reason is that, with nominal rates well below the rate of inflation, real rates have long been negative. That penalizes ordinary savers, but also institutional investors such as pension funds – who typically hold lots of bonds. Low yields mean, in turn, that to meet their on-going obligations, such investors have been forced to pursue an intensive “search for yield” – channeling money into risky financial assets and stoking up the chances of another boom/bust cycle.

Negative real rates have also been squeezing banks’ profit margins, harming their already fragile balance sheets, making them even less willing to extend loans. Far from encouraging growth, that has been further undermining economic activity.

The main reason the next move in rates will be up, though, is clearly concerns about rising inflation. Last Thursday, the Bank issued a sharply increased inflation forecast for next year, predicting that the rate will almost triple. The MPC now expects inflation to hit 2.7pc next year, it said in the latest quarterly Inflation Report, up from 1pc now, and significantly above the 2pc target. “There are limits to the extent to which above-target inflation can be tolerated,” said the Inflation Report – a sign rates could rise if price pressures escalate.

Some credible research bodies are making even more dramatic inflation forecasts. The National Institute for Economic and Social Research now thinks UK inflation will quadruple to about 4pc in the second half of next year, cutting into real disposable incomes. The rise in prices will “accelerate rapidly”, it said last week, its revised inflation outlook sharply higher than the 3pc forecast it made in August.

The main driver of expectations of higher UK inflation, of course, is the fall in sterling since the Brexit vote, which is driving up the price of imported goods. And given the crude oil spent the first quarter of 2016 below $35 a barrel, with prices now much higher – despite mix signals from the Opec exporters’ cartel regarding its ability to limit production – there are growing concerns energy price inflation could loom large during the first part of next year.

For now, though, Carney and other MPC members are indicating that higher inflation will be accommodated “for a period of time”, citing “the volatility in sterling” and “risks to growth”. There also the fact that, having cut rates just three months ago, to about turn and raise them anytime soon would be a big blow to the bank’s credibility. Then there’s that other on-going problem – the Bank of England is petrified, like every major Western central bank, that if it raises rates then financial markets could take serious umbrage.

While last week’s Inflation Report was eye-catching, the real story at the Bank last week was Carney’s decision to stay. When he started the role in July 2013, the Governor said he intended to serve five years of a maximum eight-year term, but late last year said he was reconsidering.

Then came Prime Minister Theresa May’s party conference speech last month, in which she criticized the Bank. “While monetary policy – with super-low interest rates and quantitative easing – provided the necessary emergency medicine after the financial crash, there have been some bad side effects,” she said. Carney took this as a slight, indicating he could soon be leaving. Last week we learnt that he will, in fact, stay on until the end of June 2019 – a year longer than previously indicated – by which point Britain is due to have left the EU.

Like many economists who backed Brexit, I felt Carney went far too far during the referendum campaign, with his politicized warnings from Andrew Marr’s Sunday Morning sofa that the UK would likely fall into recession in the immediate aftermath of voting to Leave.

His headline grabbing claim a Brexit vote represented “the greatest risk to domestic financial stability” was absurd. The greatest risk, by some margin, is a broader market implosion as the Western world tries desperately to retreat from ultra-low interest rates, while weaning investors off the financial morphine that is QE.

Having said all that, it is extremely good news Carney has decided to stay and not go off in a huff. Brexiteers who attack him so openly, while complaining loudly about Chancellor Philip are playing with fire. Equity and bonds markets, hugely over-valued, are propped up by the prospect of yet more money-printing, nailed-down interest rates and the widespread suspension of disbelief. This is no time for an unseemly row between Parliamentarians, the Treasury and the Bank of England.

Yet the Prime Minister was right publicly to question QE. “People with assets have got richer and people without them have suffered,” as she said. QE has not only driven inequality, but hammered savers and damaged pension schemes, while subsidizing badly-run banks which should have been forced to restructure. All that, with little meaningful public debate and – note this with regard to the latest Brexit news – no Parliamentary vote.

I have vivid memories, almost a quarter of a century ago, of drinking beers and shooting the breeze with Carney. We were at university together, pursing the same advanced economics degree amidst the dreaming spires. Then, as now, Carney combined brains and charm. He also kept goal – with some distinction – for the university ice hockey team.

I remember us discussing Wayne Gretsky – ice hockey’s equivalent of Pele and Bobby Moore combined. “I skate to where the puck is going, not where it’s been,” Gretsky once famously said, suggesting that not only technical skill but, above all, anticipation and foresight made him the player he was.

If he’s to salvage his reputation, and become the Gretsky of central banking, Carney will need the same anticipation and foresight in abundance over the coming years. That and a helmet, gum shield and plenty of protective clothing.

http://www.telegraph.co.uk/business/2016/11/05/changed-expectations-on-interest-rates-are-welcome/

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