Sunday, July 29, 2018
Will they or won't they? A big moment for the Bank
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.

We have arrived at another of those moments for the Bank of England, for two reasons. Markets, not for the first time, expect the Bank to provide a cooling draught in the summer heat by raising interest rates on Thursday. And there is also keen anticipation among Bank-watchers about a new form of guidance on interest rates it will release at the same time.

Let me take the two things in turn. Market expectations of a rise in interest rates this week from 0.5% to 0.75% are, as I say, high, roughly 90%. I do not need to tell you that we should treat these expectations with caution. They have been wrong before on rate rises and were spectacularly wrong in both Britain’s EU referendum and Donald Trump’s presidential election victory.

Markets do not, however, operate in a vacuum. Expectations of a rate rise this week were boosted by a narrowing of the monetary policy committee (MPC) vote to leave them on hold to just 6-3 last month, with one of the three including the Bank’s chief economist.

Unlike in May, there has been no real attempt to pour cold water on the prospect of an August rise. Then, anticipating a weak first quarter, Mark Carney nudged the markets away from a rise. This time the Bank has been mainly happy to go with the flow. The closest to a dampener was a speech by deputy governor Sir Jon Cunliffe, who argued in favour of “stodginess” in raising rates.
If markets are disappointed on Thursday by the absence of a hike they will have some justification.

For me, it comes down to a battle between two arguments; those based on the data and those arising from the strategic. As I wrote here a couple of weeks ago, the argument for a rate hike based on the data is rather a weak one, an argument that has been reinforced by subsequent news.

Thus, inflation stayed at 2.4% last month rather than picking up, earnings growth decelerated, retail sales fell, though not by enough to derail a strong second quarter and the overall growth bounce in April-June, to an expected 0.4%, is modest by past standards.

The debate does not, however, end there. The Bank does not just rely on back data, the rear view mirror, in making its decisions, but what it anticipates about the future. In this, two things are important: the economy is close to full capacity, as evidenced by, among other things, the lowest unemployment rate for more than four decades. At the same time, its speed limit – its ability to grow – has come down in the Bank’s estimation to about 1.5% a year, not much better than half what it was in the 2000s.

It does not, in other words, take much growth to put upward pressure on an economy already close to capacity. The fact that recent data do not suggest it is yet happening, far from excludes it happening in the future. On a forward-looking view, notwithstanding the potential for further Brexit-related economic damage, the case for a rate rise is stronger.

It is also stronger if you believe, as many central bankers do, that it is healthy to “normalise” interest rates, in other words take them away from the emergency settings established during the financial crisis. That is part of the strategy of the Federal Reserve in America, which already has several rate rises under its belt, and will sensibly ignore Donald Trump’s expressed displeasure at rate hikes.

Normalising rates is justified by the distortions created by years of ultra low rates, including what official figures suggest is a collapse of Britain’s savings culture. It also mean central banks need not go naked into the next downturn, with barely a rate cut at their disposal.

It will be a close-run thing and I would be very surprised if we see a unanimous vote from the MPC this week. There was no unanimity, remember, when the MPC voted for its first increase for more than 10 years last November, reversing the post-referendum rate cut. It will be no surprise if the Bank hikes this week but equally nobody should be too shocked if the Bank decides to put it off.

The normalisation argument for raising rates brings up the question of what is normal now for official interest rates. That is the second significant thing the Bank will do this week. It will provide an estimated for what is known as r* (r-star). R* sounds more complicated than it is. It simply provides an estimate of the neutral or equilibrium real interest rate. It is the interest rate which, as the Federal Reserve Bank of San Francisco defines it “is consistent with full use of economic resources and steady inflation near the target level”.

R* provides guidance on where the MPC thinks it might end up after a sequence of interest rate rises. The Fed has been providing such guidance for some time.
What will the Bank’s be? Allan Monks, an economist with J P Morgan, an investment bank, suggests the Bank may opt for an r* of between -0.5% and zero, in other words, a marginally negative real rate. To put that in numbers people will find more familiar, that translates into an actual interest rate of between 1.5% and 2%.

As an idea of the kind of destination the Bank has in mind it makes a lot of sense. It is, of course, a far cry from the 5% Bank rate typical before the crisis or the 12% average of the 1980s, though the Fed’s experience has been that the neutral rate is not set in stone and varies with circumstance. Those accustomed to previous Bank guidance will recognise that as par for the course.

Many things will affect the direction and ultimate destination for interest rates in coming years. Brexit is one big factor but so, as Ben Broadbent, another deputy governor, said last week, is the pace at which the Bank unwinds it quantitative easing (QE). The more QE the Bank reverses by reducing the assets it bought under the policy, the less will be the need for rate hikes.

We are not there yet. The Bank’s guidance on QE is that it will not begin to be reversed until interest rates have reached about 1.5%. After that, any further tightening will take the form of both raising rates and unwinding QE. Any need to relax policy would at first be through rate cuts.

There is a lot happening there and, whatever happens on Thursday, we are moving into a new phase for monetary policy.