The interest-rate decision by the Bank of England’s Monetary Policy Committee on Thursday 2 November — shortly after we went to press — has been a will-they-won’t-they cliffhanger for weeks. Pundits have hung on every word spoken by governor Mark Carney, searching for stronger or weaker hints.
So I’m sorry to throw cold water on all the excitement by announcing that in fact the decision is all but irrelevant. If the Bank’s base rate has indeed gone up a quarter-point, as was almost universally expected, it will merely have been a reversal of the knee-jerk emergency 0.25 per cent rate cut just after the UK voted to leave the EU last June. What is far more important is the long-term path.
When, if ever, will rates start to increase regularly in a sustained series of steps? And how high will those steps take them before the next recession?
Of all the big central banks in the world, only one — America’s Federal Reserve, led by Janet Yellen — has seriously begun the process of tightening its monetary policy. So what can we learn from the US experience?
In December 2015, the Fed raised its most important indicative rate for the first time since the financial crisis, from 0.25 to 0.5 per cent. At the time this was thought to be the start of a ‘normalising’ of rates — taking them back towards their long-term average of around 5 per cent. But this has not happened: the ‘Fed Funds’ rate is still extraordinarily low at just 1.25 per cent.
In total so far, the Fed has increased rates only four times, with a quarter-point rise roughly every six months. This meagre one percentage point total increase is far less than was expected when tightening began. At the time, the rate-setting committee gave indications that it expected to raise rates eight times up to the middle of 2017. But we’ve had just half of that, and these hikes are far less than those that occurred in the past.
Between the beginning of 1994 and the summer of 1995, the Fed Funds rate increased from 3 per cent to 6 per cent; between the summers of 2004 and 2006, it increased no fewer than 17 times, taking it 4.25 per cent higher in total.
So the current speed of US rate-tightening is both far slower than had been originally expected and far, far slower than has happened in recent history.
And the reasons behind this are low inflation, sluggish growth and an economy that has become dependent on cheap debt. That sounds very similar to the situation in the UK — with the exception that our inflation rate has blipped upwards. But even with that factor in mind, our rate hikes will probably be as meagre as in America, and unlikely to echo even the cautious 2.25 per cent rise the Bank of England imposed (in ten steps with one brief reverse) between 2003 and 2007.
Although the latest UK CPI figure, at 3 per cent, shows inflation at its highest level for five years, this spike is expected to be temporary. It is mostly due to the fall in sterling since the EU referendum feeding through to higher import prices. Most economists are forecasting inflation will fall again next year.
And the key to all this is wage growth. UK unemployment is at a 42-year low of 4.3 per cent, while the equivalent figure in the US is 4.2 per cent. And yet wage growth in both countries is minimal.
Normally such low levels of unemployment would prompt wages to rise, and historically that has been linked to higher inflation. But neither wages nor inflation are rising in the way they have in the past. That’s a mystery, according to Janet Yellen, speaking to the recent annual IMF gathering in Washington. But without wage growth and the corresponding higher inflation, interest rates are not going to go up much. And that means continued cheap credit, over-indebted consumers and a lack of savings — none of which is ideal.
However the real question is that if interest rates are not going much higher, what will happen in the next recession? This recovery, which began in 2011-12, is already five years old. According to historical patterns this would suggest a downturn has to be coming soon. But if rates are not increased back to more normal levels, then they cannot be cut as a measure to counteract the next recession.
So we’ll have to get out of it by other means, whether that’s another big bundle of quantitative easing, with its distorting effect on asset prices, or fiscal measures and a reversion to Keynesian public spending.
Whatever happens, the traditional and proven tool of interest-rate management isn’t going to be available. And that is far more of a big deal to the economy than whether rates went up by 0.25 per cent this week.