UK Interest Rates – putting off the inevitable

Higher interest rates are on their way but are still too scary to talk about

An economic recovery is a timid creature that can be scared away merely by saying the wrong thing.  That is the implication behind statements coming out of the Bank of England which has played down the possibility of higher interest rates.  The Bank of England cut interest rates to a record low more than five years ago, but improvements in the UK economy mean that we are nearing a time when interest rates will have to return to “normal” levels.  This may still be a fair way off considering that the Bank of England seems to think that the subject is too frightening to even discuss.

Why are higher interest rates needed?

It may seem funny to talk about fears in the market at a time when UK stocks are near record highs.  However, many of the gains over the last few years have come with the support of central banks.  Low interest rates coupled with quantitative easing have prompted investors to dive into the stock market in search of better returns.  The property market has also benefited with asset prices in general booming despite the weak economy.

The hope has been that the extra wealth generated as a result of rising asset prices would prompt people to spend more.  This plan has worked to a certain extent with consumer spending being one of the main drivers behind the economic recovery in Britain.  Yet it has also created a problem in that a reversal in this new-found wealth will have the opposite effect and send consumers running for cover.  This line of thought suggests that it would be great if interest rates could be kept at the current low levels.  However, an increase is inevitable.

The main concern for any central bank is that cheap borrowing will create excessive demand and push up inflation.  Your Neighbourhood Economist has argued that these worries about inflation tend to be overblown.  A more pressing problem comes from the UK property market.  Housing prices have surged upward, recovering at a rate considerably faster than that of the overall economy.  This suggests that such gains in property prices are likely to be unsustainable and may cause trouble in the future.  This situation is made worse by the UK government being unwilling to offer much help in stimulating the economy.

What is so scary?

The central bank is caught at a junction where the long-term costs of low interest rates are becoming more obvious relative to the short-term benefits.  Acting too soon could damage a still fragile recovery while problems such as the booming property market could get out of hand if interest rates stay low for too long.  There will be a point where the Bank of England decides that worries about a premature interest rate hike outweigh that of the potential long-term costs but we haven’t reached that stage yet.

The caution shown by Carney in his recent statements suggests that the UK has yet to approach a point where higher interest rates can even be discussed as a possibility.  This partly reflects the possible outcomes facing the Bank of England.  A stalled economic recovery that results from a hike in interest rates would be one of the most dreaded outcomes for a central bank.  On the other hand, the effects of problems such as a housing bubble or excessive debt are only felt years later.

Low inflation adds to the reasons why the Bank of England might take a more cautious approach.  Inflation is not likely to cause trouble anytime soon given weak gains in wages and a strong pound.  A further factor to consider is that the Bank of England will feel the need to forewarn both borrowers and investors that higher interest rates are on their way.  All this points to a hike to interest rates being a bogeyman for some time to come.