Unit 2 Macro: Should UK Interest Rates be Rising Now?

In remarks made when launching the new quarterly inflation report (May 2014), the Governor of the Bank of England, Mark Carney, has signaled that policy interest rates set by the MPC are likely to remain at historically low levels for some time to come. The first rise in rates is probably less than a year away and some economists have penciled in early New Year 2015 for a rate hike. But what are some of the arguments for raising interest rates now?

Mark Carney delivers the latest BoE inflation report

Bank of England Growth Projection

The case for an immediate increase in policy rates

1. The UK housing market is strong at the moment with average prices nearly ten per cent higher than a year ago. New house building is picking up (good for cyclical growth and jobs) but we have seen before the risks associated with double-digit property price inflation and the BoE's MPC and Financial Policy Committee (FPC) ought to be thinking of controlling this boom before another housing bubble materialises.
2. Some people argue that the UK economy has become too dependent on ultra-low interest rates and that a return to more 'normal' monetary policy conditions is needed for growth to become more balanced and sustainable.
3. Higher policy rates are needed to increase the rate of return for savers, millions of whom have suffered from negative real interest rates in the years since Global Financial Crisis engulfed the economy
4. There are some risks of accelerating inflation in 2015 and beyond. Raising interest rates now takes time to have an effect on the macro-economy - conventional theory suggests that the full effects of a tightening of monetary policy can take between 1 and 2 years. A rate rise now would signal that the Bank of England remains serious about keeping consumer prices inflation at or around the 2% target level over the next two years
5. Starting to raise interest rates now by small 0.25% steps would prevent the need for larger rate rises in the future if the growth of the economy turns out to be stronger than the Bank currently expect. The risks to the recovery of doing so is small and higher interest rates would help to re-balance the economy without a big threat to unemployment. Interest rates need to rise before an economy over-heats not once we find that it is already happening

Bank of England inflation projections

The case for holding interest rates at their current level of 0.5%

1. House prices are indeed rising at a rapid rate but not across the whole country. What is happening in the London housing market for example should not dictate movements in policy interest rates that affect the whole country. Many home-owners are stretched to meet their monthly mortgage payments and higher interest rates would be a big threat to vulnerable first time buyers. The housing market can be cooled with measures other than a rise in interest rates - such as a tightening of the criteria used by mortgage lenders when making loans.
2. Although cyclical GDP growth has rebounded during 2013 and into 2014, by most estimates there remains plenty of spare capacity (or productive slack) in the economy - the estimated output gap is still negative - and the Bank of England is right to keep policy interest rates on hold until there is more evidence that the economy has reached normal levels of capacity utilization
3. CPI inflation has fallen below 1.6% and wage inflation remains subdued. Unit labour costs are growing by less than 2% There is little risk of a big acceleration in inflationary pressures that would justify policy rates moving higher
4. The sterling exchange rate has been appreciating in the currency markets over the last year. It is now 10% higher on a trade-weighted basis than twelve months ago. A decision by the Monetary Policy Committee to raise interest rates might lead to further inflows of hot money into the UK banking system, driving the pound higher against the US dollar, the Euro and other countries. A strong pound keeps inflation lower but risks damaging UK export performance and widening an already large current account deficit on the balance of payments.
5. Growth has been picking up in the UK but there are increasing fears of a deflationary slowdown or new recession in the Euro Zone. Weaker growth in the EU will harm the UK's export industries. Over half of all UK exports go to the rest of the European Union (EU) – this corresponds to almost 15% of national income.

Adapted from newspaper reports:

The Bank of England says it is no rush to raise interest rates, stating that securing recovery was like qualifying for the World Cup but now Britain’s economy needed to win it. Bank Governor Mark Carney indicated that there was no plan for an early rate rise to cool the property market.

It said slack in the economy could keep rates down, while unemployment would fall faster than expected, growth was on track and inflation was likely to stay low.

Hamish McRae - writing in the Independent (May 2014)

"This can't be right. Growth is running at around 3 per cent, and projected to carry on at much that level. The economy is creating jobs at a rate of more than a million a year. Unemployment is now clearly below the 7 per cent threshold that the Bank of England indicated nine months ago it would consider increasing interest rates at. Share prices yesterday hit a fresh 14-year high. House prices are going up by 11 per cent a year. And interest rates are to stay at 0.5 per cent until well into next year? Common sense says this must be wrong."

Read the article here: http://www.independent.co.uk/news/business/comment...

More background on the UK economy is available from the Bank of England's Inflation Report page

http://www.bankofengland.co.uk//publications/Pages...

Article on the Bank of England from the Guardian can be found here:

http://www.theguardian.com/business/bankofenglandgovernor

Revision slides on Monetary Policy and the Exchange Rate (Tutor2u)

AS Macro Revision: Monetary Policy and Exchange Rates from tutor2u