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Author: Alan Shipman

G-rate expectations

Updated Tuesday, 29th July 2014
A pre-election rise in interest rates would confirm Britain’s economic recovery. And might also sink it, writes Alan Shipman.

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Illustrations of different sporting events highlighting a struggle between Wages and Prices, Earnings and Expenditure, the Fallen Economy and Interest Rates. The cartoon is titled Introducing a different version of the Commonwealth Games.

Most governments inwardly groan when their central bank decides to raise interest rates. In a country where a majority of households are home-owners, most owner-occupiers have mortgages, and most of these are at variable rates.

A rise in the Bank of England base rate means more suffering borrowers than rejoicing savers. The only reason they don’t groan out loud is that it’s now fashionable for central banks to be independent, so politicians don’t want to be seen (or heard) trying to sway their decisions on who can borrow at what price.

But Chancellor George Osborne, overturning history, will celebrate the increase when it comes – hailing it as the final confirmation that his strategy has turned the economy round. Raising the cost of borrowing, from the floor to which it was hurriedly pushed in 2008, is now a virility symbol for the world’s finance ministers. The Eurozone can’t do it: indeed, its European Central Bank was recently forced to push its base interest rate below zero to fend off the price deflation now threatening due to lacklustre growth.

The US isn’t expected to do it for at least another year, its economy having shrunk again in the first quarter of 2014 as appalling weather knocked industrial production down.

So the UK, alone among major economies, has the strength to pay more for its borrowing. Carney, whose ‘forward guidance’ initially suggested there might be no rate rise until 2016, now says it will come “sooner than the markets expect”, which could mean it is only months away. Monetary Policy Committee  members, in line with this, are hinting they’ll start voting for increases soon.

The move into an increasing rate cycle will also see a winding-down of ‘quantitative easing’, the direct financial injections that have nursed the financial sector back to health since its bruising encounter with ‘credit crunch’.

Conflicts of interest

While an interest rate rise will be taken as a sign of renewed economic strength, there’s still a lot of doubt about how much of that strength would survive it. Fears are centred on the millions of households, who, according to research by financial regulators and by the Resolution Foundation, may be only one rate-rise away from serious financial problems because of their existing debts and lack of income growth. When their borrowing costs rise, their spending could be squeezed again, sapping businesses’ confidence and investment plans.

A domestic spending squeeze could be good for recovery if it prompts businesses to refocus on exports, narrowing the external deficit that has risen to record levels as UK growth moves ahead of main EU partners’. But the prospect of UK interest rates rising, while the Eurozone’s are falling, is already strengthening the pound, making it harder to sell more abroad.

This year’s stronger economic growth is not the sole reason for raising rates. With GDP only just returning its peak 2007 level, there still appears to be plenty of spare capacity, with the ‘output gap' (between actual and potential production) down but by no means out at the start of this year.

As a result, there is little immediate risk of medium-term inflation moving back above the official 2% target: lower food prices dropped it to 1.5% in May. The demand for higher interest rates is mainly being stoked by fears of another house-price bubble, radiating outwards from London. That’s why business secretary Vince Cable is alarmed at the possibility of companies’ borrowing being staunched by measures designed to restrain home-buyer borrowing - and keen to overturn rules that still make it easier to borrow to purchase a house than to pursue a bright business idea.

The need to ‘rebalance’ the recovery, by inducing households to pay down their existing debt and save more, is another motive for raising interest rates early. But higher rates before the crisis weren’t enough to stop a trend decline in household saving. It took the 2008-11 house price crash, and subsequent deep cuts to the welfare budget, to make people tighten their belts and put more aside. So if interest rates rise before the next general election, look for the chattering teeth behind the Chancellor’s smile.

It could be the Coalition’s own Gary Lewin moment - a celebration of unexpected achievement that puts an early end to enjoyment of the rest of the contest, just as the England football team’s physiotherapist did when he came home to put the tea on for the welcome home party for manager Hodgson’s underachievers.

This blog post is part of Society Matters. The blog seeks to inform, stimulate and challenge our understanding of this changing world and of our humbling role within it.
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Please note: The opinions expressed in Society Matters posts are those of the individual authors, and do not represent the views of The Open University.


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