From 2009, following the financial crisis, the UK base rate had been at the lowest level at 0.5% since the inception of the Bank of England in 1694. Interest rates were further slashed in August 2016 by 25 basis points in the aftermath of the announcement of Britain leaving the European Union.
UK households may be forgiven for thinking that interest rates are likely to be at the sub 1% mark for the future due to the Bank of England continuing to stimulate the economy through promoting consumption and investment whilst reducing the incentive to save.
However, the impacts of this misconception could be extremely severe, and potentially could lead to another financial crisis, especially with the emergence of consumers becoming more highly leveraged in the car loans market as well as impacting bond yields.
Why Rates Remain Unchanged
The Bank of England has left its policy unchanged in a recent Monetary Policy Committee (MPC) meeting, with the base rate at 0.25% and no changes to the Quantitative Easing scheme. UK inflation in June was 2.6%, having dropped from 2.9% in May, reducing the pressure on the Bank of England to raise interest rates. This can be shown by the fact that the voting pattern was a more dovish split of 6-2 in favour of keeping the base rate at 0.25% compared to the 5-3 split in June. Nevertheless, inflation is still above the target of 2% so there could be a change to a hawkish stance in the near future.
Before the August meeting, some speculation was building in the markets that Andy Haldane, the chief economist at the Bank of England could have joined the two hawks in the MPC by voting for a rate rise. Although this did not happen, after the meeting, the deputy Governor Ben Broadbent hinted that interest rates may go up by more than market expectations. He believes UK households will react significantly better to an interest rate rise compared to the years preceding the financial crisis as consumers credit compared to incomes is lower and because interest rates are currently lower than they have ever been.
On the other hand, Mark Carney, the Governor of the Bank of England, said that the uncertainty surrounding Brexit is diminishing business confidence leading to lower levels of investment and is also negatively impacting pay negotiations.
There is extremely sluggish and even negative, real wage growth showed by a 0.5% in real wage earnings in July 2017 on an annualised basis as inflation outpaces nominal wage growth. This means consumers’ purchasing power, taking into account inflation, has been falling and could be a reason why the Bank still believes in stimulating the economy through low-interest rates. With unemployment in the UK at low levels unseen since 1975, the Phillips curve suggests that real wage growth should be rising. How can a seemingly tight labour market not be pushing up real wages?
One reason could be that the UK labour market isn’t as productively efficient as suggested due to significant levels of underemployment as workers who prefer to work full-time are pressured to work part-time. The absence of a labour market with fully employed resources could explain why real wages aren’t rising, as predicted by theory.
Additionally, UK employers are facing other cost pressures including the rapid rise in production costs, such as raw materials, due to the depreciation of the pound. For example, following the announcement of the Bank of England’s dovish stance in the August meeting, the pound dropped 0.76% against the Euro which will undoubtedly further increase costs for firms.
Finally, the growth of the ‘gig’ economy has transformed the labour market by forcing it to be more flexible, allowing unemployment to fall. However, this has made workers more concerned about their job security and less willing to negotiate for higher wages, reducing real wage growth.
Looking to the Future
The Bank of England has downgraded the 2017 growth forecast from 1.9% in May to 1.7% reflecting the slow and steady rises of output by 0.2% and 0.3% in quarter 1 and quarter 2, respectively. Furthermore, it believes GDP growth in 2018 will be 1.6%, down from the original 1.7%, while maintaining its prediction for 2019 at 1.9%. It estimates Consumer Price Index inflation to peak at around 3% in October this year followed by a continued overshoot of the 2% target in the three-year horizon. However, there is a strong implicit assumption that the Bank of England has made when calculating these estimates.
It has assumed that the UK’s exit from the European Union will be a smooth transition process and that Theresa May will be able to broker trade deals which are similar to the current European Union agreements. Thus, if this strong assumption is not met, GDP growth will likely be significantly lower and inflation, perhaps caused by a further depreciation of the pound, will continue to rise. This could lead the Bank of England to raise the base rate to combat inflation, and the government to actively pursue an expansionary fiscal policy to promote domestic growth.
It is difficult to say how the Bank of England will react in the upcoming months due to the significant ambiguity surrounding Brexit and the corresponding negotiations, but currently, the MPC could vote for a tighter stance in the near future due to its prophecy of persistent and potentially rising inflation.