Sunday, October 19, 2014
Bank may eventually rue leaving rates low for too long
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

Even before the stock market had an attack of the vapours, other factors — a sharp fall in Britain’s inflation rate, renewed weakness in the eurozone, and doubts about the strength of the job market — had led some in the City to push out their expectations of when the Bank of England will begin to lift interest rates.

Some, having thought the Bank would begin raising rates early next year, now think it will not happen until the second half of 2015, or possibly not even then.

Sure enough, on Friday morning Andy Haldane, the Bank’s new chief economist, offered plenty of succour to the “lower for longer” school on interest rates. Haldane, who said in June he marginally favoured being on the front foot on rates – raising them earlier – said he had now shifted to the back foot, mainly because he was on balance gloomier about the economic outlook.

Though his comments could be taken to mean that he thinks the peak for rates will be lower than he thought, they have been universally interpreted as signalling a delay in the first rate hike until later. And, while he is only one vote on the MPC, it is likely that his view is close to others in the Bank, including Mark Carney, the governor.

I shall return to the Bank in a moment. First, let me look at some of the other elements. The drop in inflation from 1.5% to 1.2% in September, its lowest for five years, was welcome. We should be wary, however, of concluding that Britain is about to join parts of the eurozone in experiencing deflation — falling prices.

Core inflation in Britain, excluding the more volatile energy, food, alcohol and tobacco components, is running at 1.5%. Service sector inflation, a better guide to domestic inflation, is running at 2.4%. Retail price inflation is 2.3%. Deflation is some way away.

Britain’s inflation rate is likely to run at close to 1% for the next two to three months. Next year, however, it is much more likely to rise than fall, pushing back up toward 2%.

Is the job market weakening? There has been a record annual fall in unemployment of 538,000 over the past year, taking the level down to 1.97m and the rate to 6%, a full percentage point below the earlier 7% forward guidance threshold (for considering rate hikes) which, a year ago, the Bank did not expect to be hit until 2016.

The weakness was that in the latest three months (June to August) employment rose by only 46,000, its smallest quarterly increase for more than year. Annual growth in total pay was only 0.7%, below even the lower 1.2% inflation rate.

The small rise in employment looks, however, to be misleading. The monthly numbers show there was an unexplained drop in employment in June, followed by strong increases in July and August. When June drops out of the three-monthly comparison in the next set of figures we should see stronger employment growth, and this concern will subside.

As for pay, something odd is happening there too. We expected weakness in bonus payments in April and May because a year ago people shifted their incomes to take advantage of the cut in the top rate of income tax from 50% to 45%. Even in August, however, with the exception of public sector bonuses (which for some reason showed a 75% annual rise), bonuses continued to fall. A better guide to wages is regular pay, which in August was 1.2% up on a year earlier. The big picture remains one of a strong job market, alongside weakish wages.

Where there is cause for concern, apart from the risk that market turmoil could become self-feeding, is in the eurozone. We knew the eurozone’s growth problems had transferred themselves to its three big “core” economies, France, Germany and Italy (which, to be fair, has long been weak) — but what also emerged in recent days were what could be the first murmurings of a re-run of the eurozone’s sovereign debt crisis, centred initially on Greece again. That should be watched closely.

So what should the MPC make of all this? A 2014 rate rise has been off the agenda for some time. The question now is when, or if, the Bank will start to hike in 2015.

On inflation, you will remember the MPC decided to “look through” the high inflation of recent years, which at one time hit 5%, because it was mainly due to global rather than domestic factors. Logic suggests it should do the same for the current low rate of inflation, explained by weak energy and commodity prices and the earlier strength of sterling.

As for the labour market, the key issue is that the further unemployment falls the less slack there will be in job market. The unemployment rate, as noted, is already well below the level at which the MPC had said it would consider rate rises. On wages, there is nothing in the latest figures to change the Bank’s view that a recovery in wage inflation — mainly next year — is still on the cards.

So I have some sympathy with the views of Weale, one of the two rate-hikers on the MPC in recent months. He put it well in a lecture a few days ago. He would, he said, consider what was happening in the eurozone and the wider international economy in deciding on his MPC vote. But his main focus domestically would be on the rate at which spare capacity was being used up in the economy because this provided a good guide to what would happen to wages. “The best indicator of this is probably the rate at which unemployment is falling,” he said.

Of course the MPC should not be raising rates if markets are in turmoil, or if the eurozone returns to its darkest days. Though the dangers of the latter are clearly there, I still think we have moved beyond fears of euro break-up and a re-run of the sovereign debt crisis.

But I also think the MPC should, as Weale says, be thinking about the fundamentals of a tightening labour market and the fact that the current weakness of inflation is likely to be temporary.

In the end, there are always reasons to delay raising rates, particularly when they have been low for so long. But, having prepared the ground for rate hikes in the first half of next year, the Bank would be unwise to kick things too far into the long grass. That would make the eventual decision harder but could also mean bigger increases will be needed when the time comes. The Bank may regret leaving rates low for too long.