Economy not ready for UK rate rise
The high price of preserving credibility
by Danae Kyriakopoulou in London
Fri 3 Nov 2017
For once, the Bank of England followed through on its signal to markets, raising interest rates on Thursday for the first time in a decade to 0.5% from a record-low 0.25%. It had little choice but to do so. Since becoming governor four years ago, Mark Carney had set the scene for interest rates to rise multiple times. Until yesterday, he had delivered nothing but a rate cut after last year's referendum to leave the European Union, earning him a reputation as an 'unreliable boyfriend'.
The Bank's concerted effort since the summer to indicate that markets should expect a rate rise meant the announcement was broadly priced in. Overnight index swaps on the eve of the announcement had been pricing in around a 90% probability of a move – far higher than before any meeting during Carney's tenure. So priced-in was the move that not only did sterling not jump on the news, but rather it fell nearly as much as it did in the immediate aftermath of the Brexit referendum. This was because of the dovish tone of the longer-term outlook, defying the standard textbook relationship between rates and the value of the currency. From a credibility perspective, therefore, yesterday's move was a success.
But there are serious doubts over whether it was the right choice for the economy. The BoE's mandate dictates it to deliver price stability (interpreted as low inflation and defined by the government's target of 2%), in the broader context of setting the right conditions for growth and employment. With inflation running at a full percentage point above this target, the narrow case for tightening was compelling. This was further supported by indications of diminishing economic slack. Unemployment, at 4.3%, is at its lowest level in 42 years, while GDP has recorded growth for 19 consecutive quarters, and at a pace higher than forecast by the BoE after the referendum.
But these statistics all only tell part of the story. Growth may be strong, but it is slowing. The uncertainty around the parameters of the UK's exit from the EU has weighed on business and consumer confidence. The Bank warned that 10,000 jobs could leave the City of London after Brexit, and acknowledged that forecasts of 75,000 job losses over the long-term were 'plausible'.
Moreover, even the pick-up in inflation makes for an unusual backdrop for a rate increase. Far from an indication that the economy is growing so fast that it is overheating, inflation is being driven above its target by the weakening of the pound and the slide in the economy's long-term trend.
The 25 basis point increase seems inconsequential and is hardly visible on a longer-term chart of rate movements. Excluding last summer's Brexit-induced cut, rates remain at almost record-lows. What matters now is whether the decision precipitates further rises and what form any new tightening would take.
When asked whether he was comfortable with the market forecasts for two more rate increases during the next three years, Carney's response at the press conference could broadly be translated as 'Yes'. He added that any additional rises would be limited and gradual. While it is tempting to build on the success of its market communication and forward guidance in yesterday's decision, the Monetary Policy Committee should avoid doing so. As the Bank acknowledges, the economic outlook and market environment remain highly uncertain, and it would do well to keep its options open. There is a strong chance yesterday’s increase may need to be reversed.
Danae Kyriakopoulou is Chief Economist and Head of Research at OMFIF.
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