• Bank of England Governor Carney says UK rates will increase gradually
• They need to be lower than in the past to keep the economy operating at potential
• Rates could be restrained by imbalances between global saving and investment
The Bank of England Governor Mark Carney recently commented that the point at which interest rates will begin to normalise is getting closer. However, he added that rates will need to be lower than in the past to keep the economy operating at its potential.
“…The precise timing of the first rate rise is less important than our expectation that, when rates do begin to rise, those increases are likely to be gradual and limited. …”
The UK is an open economy with 50.5 percent of its exports going to the European Union (EU). Therefore, it is only correct that the governor highlight the problems that the UK can face given the quieter level of demand in such a major export market. It is also the case that whilst independent of the government, the BoE has to keep an eye on the current and post May 2015 plans that the government of the day will have for the deficit level, taxation and the impact on a debt-laden private sector. These should all be regarded as factors that can temper the central bank's potential to raise the base rate.
The Sterling Overnight Rate or SONIA did make a small step lower at the start of September when the outcome of the recent Scottish Independence Referendum was in doubt, however, since the “No” campaign won the decision on September 18, it can be seen to be ticking higher.
Source: Bank of England and British Bankers Association
Earlier this month, the Office for National Statistics (ONS) reported that the UK unemployment rate had fallen to 6.2%, its lowest since October 2008. Given that the initial “intermediate threshold”, announced in August 2013, for the BoE to start considering whether the policy stance remained appropriate was 7%, should the markets behave as SONIA is and start preparing for an imminent hike in the Bank rate?
The tightening of labour market conditions and the understandable concern that this could herald a sudden burst of wage inflation was behind MPC members Martin Weale and Ian McCafferty’s decision to vote for higher rates at both of the last two Monetary Policy Committee meetings.
However, there is a problem with such analysis. It is that the unemployment rate provides only a partial impression of the current amount of slack in the labour market. To grasp a more complete and therefore more meaningful impression, one has to take account of the people currently working part-time but who would prefer to work full-time, however, are unable to do so. Coupled to that we need to factor in those in temporary employment and unable to secure a permanent position. Once we do this, a very different picture emerges.
Source: ONS, Spotlight Ideas
Expressed in these terms, we find that in addition to the two million people who were out of work but actively seeking employment in July there were a further two million who were “under” employed. That means the effective pool of labour resources that is available to be put back to productive use in the UK economy is a fraction under four million. Of course, this is more than 600,000 less than was the case in January 2012 at the cyclical peak. However, it is still a high figure at 12.2% percent of the labour force.
The takeaway is that the amount of slack in the labour market is therefore significantly greater than is generally recognised and the implication is that the UK economy can create at least a million more new jobs before running into capacity constraints.
Given this, the MPC can afford to take its time in tightening monetary policy. I now do not expect the first increase in Bank Rate (25 basis points) until at least May 2015. As I said earlier, the BoE is, of course, independent. That said it is hard to imagine the rate trigger being pulled before the next General Election which should be on May 7th 2015.
Once rates are moved, say in June, I expect 25 basis point increases to follow every quarter after that until 2.50 percent is reached in the second quarter of 2017.