UK: After 9 years the unreliable boyfriend finally commits

In previous editions of our weekly economic update we have pointed out that after many false starts a rise in UK rates was likely to happen soon. Ever since the financial crisis unfolded the decision to commit to raising interest rates, having slashed them to avoid deflation, was always going to be difficult. On Thursday, the announcement of a 0.25% rate rise, agreed by all 9 members of the Monetary Policy Committee, did not come as a major surprise having been well flagged in advance. According to a Bloomberg poll the probability of a rise was set at 92.5% before the meeting.

The rationale for the Bank of England (BoE) raising rates is simple; the UK economy is showing tentative signs of strength, with the labour market outperforming. Unemployment is sitting at 4.2%, the lowest figure seen since June 1975. Although the relationship between falling unemployment and rising wages and prices has broken down, the expectation is that this link will establish itself again at some point. When this happens it will be positive for wealth, spending and growth. Another aspect worth bearing in mind is that real interest rates, after taking inflation into account, are negative. This means policy is very loose and it allows the BoE to raise rates now without unduly restricting growth in the future.

UK Interest Rates vs UK CPI

Source: Bloomberg, August 2018

Note: The Bank measures inflation using the Consumer Price Index (CPI). It is currently 2.4% and above the Bank’s 2.0% target. The rate rise will help mitigate the possibility of inflation moving further away from target.

If you recall from our previous weekly economic updates, the bank had been expected to raise rates in Q1 of this year. However, weak economic data forced the bank to review its plan. They suspected the soft patch in spending would be temporary (caused by adverse weather), and this has proved to be the case. Since Q1 there has been a rebound in retail sales, boosted by both the Royal Wedding and the World Cup. Stronger consumption helps underpin growth in the broader economy, measured by Gross Domestic Product (GDP).

UK Retail Sales and GDP

Source: Bloomberg, August 2018

The decision by the BoE to put up interest rates for the first time in 9 years represents a step towards policy ‘normality’. It is indicative of the bank taking tentative steps in order to avoid upsets along the rate raising journey. Yes, higher interest rates will mean higher borrowing costs for some but the context for this happening is favourable. It is indicative of more confidence in the growth outlook.

The BoE also gave some clues about what is in their thinking as regards the ‘equilibrium’ rate of interest. An equilibrium rate of 5% was thought to be needed to mark the point beyond which policy would become restrictive. New thinking is that the equilibrium level lies between 2-3%. The implication of this for cash-based savers is that cash returns will remain unremarkable for longer than they ever imagined.