Don’t be afraid of the interest rates bogeyman
ECONOMICS is full of myths that conceal reality. One myth that prevails is that higher interest rates are always bad. Maybe i t ’s because high interest rates invoke dreadful memories: certainly anyone who bought a house in the late Eighties and suffered eye-watering interest rates of 15% would think so.
Maybe it is because economists are poor at explaining their controversial art. At any rate, the lesson of history is clear: properly executed monetary policy can improve outcomes over time.
With the Bank of England signalling that it will probably raise rates next week for the first time in more than a decade, it is worth considering why they will rise and what the impact will be. Contrary to what politicians would have us believe, economic policy mostly offers trade-offs, not solutions. Judging when to raise interest rates is especially tough. Because debt and savings are unevenly distributed across the economy, changes affect people in different ways.
The job of the central bank is to decide whether there is an overall benefit to its policy decisions.
After the financial crisis, when the BoE cut its policy rate to a historic low of 0.5%, and then to 0.25% since the Brexit vote, many people complained about the sudden hit to the returns on their hard-earned savings. But these costs had to be weighed against the benefit of higher employment and stronger growth for the whole economy that would come from lower rates.
If the BoE raises rates next Thursday, it is likely to squeeze some highly indebted households but it will discourage many more from running into the same problem. The rate of UK economic growth since the Brexit vote has slowed by much less than the Bank anticipated, as, instead of cutting back on spending as inflation has risen above wages, households are opening up their wallets more to meet demand. But to do this, they are borrowing more than they can afford and saving less than they will need for the future.
So far, uncertainty from Brexit seems to be crimping supply more than demand. Households’ desire to spend is outstripping the rate at which firms can produce.
So unless households are incentivised to borrow less and save more, this excess demand will persist. And without higher interest rates, domestic inflation will rise over time even as the temporary effects of imported inflation from a weaker sterling fade.
Whenever interest rates begin to rise, understandably, people want to know how far they could go up. But thanks to globalisation and other underlying trends, advanced open economies like the UK are less prone to high inflation than in the past. Interest rates will therefore need to rise at a slower pace and to a lower level than in the past.
Threadneedle Street will probably manage to achieve its inflation target of 2% within a couple of years, with just a few small rate hikes.
An increase of to 1.25% by the end of 2019 will probably be enough to keep inflation in check. It is also worth noting that the cost of consumer credit and
‘Thanks to globalisation... advanced open economies like the UK are less prone to high inflation’
mortgages is set by market forces and not directly by the BoE, so the rise in borrowing costs for the average person is likely to be less than the increase in the base rate.
Sound monetary policy works on the basis that a longer, slower-burning expansion at full employment is better than wild swings in the business cycle that cause permanent uncertainty for workers. By leaning against the forces that cause high inflation, the Bank can lengthen the current economic expansion.
In a way, it’s a victim of its own success. Households and firms have become accustomed to low inflation over the 20 years since the Bank became independent.
They can be forgiven for forgetting that bad economic policies can still lead to destructively high inflation, which remains a real threat to the economy. Modestly higher interest rates can keep this at bay.
Kallum Pickering is Berenberg’s senior UK economist
@KallumPickering