Evaluating UK interest rates

England's odds of winning the World Cup are about 30-1 - which reflects a rather low level of confidence that we have a realistic chance. However, the Governor of the Bank of England seems to think that a safer bet would be to back the recovery of the UK economy, judging by Mark Carney's launch of the latest Inflation Report yesterday. He likened the path the economy has to follow to that of England's task in Brazil, and said that the Bank's priority was to steer the economy through the opening rounds, all the way to victory.

So a key question is whether recovery to more normal levels of economic activity will be accompanied by more normal levels of interest rates, and if so, when. At the end of last week, Robert Peston wrote a useful blog assessing whether a rate rise would be good for the economy or not. He makes the point that the UK was the first to lower rates to unprecedented levels in 2009, and to employ QE as a policy to reinforce monetary expansion, and suggests that we might well also be the first to begin raising rates again. This could happen by the end of the year, although more pundits seems to be predicting the first quarter of next year as the likeliest time - Peston suggests this may have unfortunate political consequences, which is ironic, given that the intention of independence for the MPC is to free them from political considerations in making base rate decisions. Mark Carney has signalled very clearly that when rate rises come, they will be gentle and gradual, not posing risks of an economic shock.

Why may this happen? Because unemployment continues to fall, and while so far the accompanying wage rate rises are not inflationary, they may start to become so. This depends to some extent on the remaining spare capacity in the economy, which the Bank is not too concerned about, and estimates at between 1.1 and 1.5%. The main reason would be to preempt any overheating in the economy, and based on the current expectations of growth, this may come about in the next year or so. Those expectations probably give the main reason that we can be confident of a rate rise - for example, those wanting a mortgage are already being charged a little more to borrow, in anticipation of action to come by the Bank of England. Those expectations may also be helping to drive the strengthening of sterling - which has risen by around 12% in the past year - which is helping to moderate our recent cost-push inflation by lowering prices of our price-inelastic imports.

One concern which is increasingly being voiced is about a housing market bubble, and the need to raise rates to prevent that. However, the Governor has emphasised the role of the new Financial Policy Committee, which has a range of powers to rein in banks' ability to make riskier loans and Peston suggests that "it would be extraordinary if the the Bank of England's Financial Policy Committee did not in coming weeks force banks to ration the provision of higher risk mortgages or make it more expensive to provide mortgages (by increasing the capital banks have to hold for mortgages) or both" - signalling that creation of the new committee means that the MPC can be freed from the burden of setting rates for the narrow purpose of controlling the housing market, and can consider the wider picture of the full economy instead.

So, as we watch Roy Hodgson guiding England on their way (...or not) through football's transmission mechanism of the qualifying rounds > second round matches > quarter finals > semi finals > The Final, we can liken this to the MPC steering the economy through previously uncharted waters of restoring base rates from their position anchored at the rock bottom, and deciding whether to remove QE from the money supply. How would you estimate the chances of either being successful?