Sunday, November 08, 2015
Risks start to rise as rates get stuck again
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.

Forecasts are always risky, but if I wanted to venture a couple, it would be these. At some stage next summer Mark Carney, the Bank of England governor, will make a speech warning that interest rates could be going up, perhaps around Christmas.

Then, at roughly this time next year, when it becomes clear they are not, the markets and the Bank will between them push out their expectations of the first rate hike into late 2017 or beyond.

This is not, I should say, some bold leap into the dark, though it could still turn out to be wrong. Friday's strong US jobs report put the Federal Reserve's on-off December rate hike back on again again, showing that these things can change quickly. But expecting a hint next summer from Carney that rates could soon be on the up merely assumes the governor will follow the pattern of the past two years.

In the summer of 2014, at the Mansion House in the City, and in the summer of 2015, at Lincoln Cathedral, Carney put markets, households and businesses on alert for higher rates. And, while he pointed out on Thursday that we have not yet reached the turn of the year, which is when he said the decision on rates would come into sharper relief, the tone of Bank’s latest inflation report was that everybody can stand down; rates are going nowhere.

My other prediction is not particularly bold either. All it assumes is that the history of the past few years will repeat itself and that the Bank’s monetary policy committee will continue to find more reasons not to raise interest rates than to do so. For added comfort, the market assumptions on which the Bank’s latest growth and inflation forecasts are based are for no change in rates next year.

Thus continues an extraordinary period. If, it is indeed the case that interest rates are on hold until 2017, this will be the missing decade, perhaps even the lost decade, for rate hikes. The last change in interest rates – the cut to 0.5% - was in March 2009 but the last hike was as long ago as July 2007. The last time we went so long without a rate hike was in the period which included the Great Depression and the Second World War. Bank rate was at 2% from 1932 to 1951. The last time before that was when Bank rate remained at 5% for over a century, from 1719 to 1821. I don’t think we will beat that one but these are early days.

If rates were still at 0.5% in 2018, Carney would return to Canada as that rarest of modern-day governors; never presiding over a change in rates. He still seems personally keen on getting one under his belt next year, even though the inflation report suggested otherwise. Many City economists also still have a rate hike pencilled in for 2016, though they were surprised by the dovishness of the Bank’s inflation report.

The other extraordinary thing is that the Bank, having never done quantitative easing (QE) before the crisis, is in no hurry to unwind it. Electronically creating money to purchase assets was novel in 2009. By the time the Bank gets around to reversing it, it will be old hat. A few weeks ago I suggested that the Bank might want to run down its QE to take the temptation away from politicians to launch much dodgier versions of it.

Instead, the Bank has hardened its commitment to maintaining QE. Until last week the understanding was that, as soon as interest rates started to rise, it could quietly start the process of running down its QE, by not reinvesting the proceeds of maturing gilts it has on its books. Now it says it will not do that, let alone start the process of actively selling the gilts back, until Bank rate is up to 2%, which might not be until 2020. As well as a decade without rate hikes, we would by then have had a decade or more of large-scale QE.

Does it matter? You could say it does not get much better than this. While savers have been deprived of the return on their savings they would normally have expected, borrowers are continuing to enjoy the bonus of low rates. Indeed, to be charitable to Carney, his 2014 and 2015 warnings were both scuppered by what the Bank regards as an “unforecastable” plunge in oil prices. Indeed, the latest inflation report includes a useful comparison of what the Bank expected in August last year and what subsequently happened. The halving of oil prices since then meant that instead of inflation being just below the 2% target now, as it projected, it is running at -0.1%.

You could also say that consumers have had a double-bonus from cheap oil: the fall itself and the postponement of possible rate hikes. So these are good times for households: real post-tax household incomes will rise by 3% this year and more than 2% annually for the three following years. They are also good times for businesses, with the Bank projecting a 5.5% rise in investment this year, followed by 7.5% t0 8.75% rises for the following three years. Growth is good, inflation is benign, what could possibly go wrong?

Three things. One striking thing about inflation in recent years has been how much it has been driven by factors outside the Bank’s control; the rise and fall of commodity prices, and the fall and rise of sterling. Those factors are currently blowing in a favourable direction. There is no guarantee that will continue, particularly given instability in the Middle East.

Secondly, the longer that interest rates stay low, the greater the danger of risky behaviour. House price inflation is back within a whisker of 10% according to the Halifax and consumer credit is picking up strongly. The intention of low rates is to encourage households to spend and businesses to invest. But spending can turn to splurge and judgments can become very clouded when the risk of higher interest rates appears to have been removed from the table.

Finally, the Bank’s new forecast, in which consumer spending grows by an average of 3% a year and the growth of imports comfortable exceeds that of exports each year, is one that could be expected to exacerbate Britain’s already parlous balance of payments position. In the past we would have worried about that because of the impact on sterling, and the knowledge that a plunging pound has usually meant higher interest rates. This time, so far at least, it has been different. But this time is different does not usually work as a long-term plan.