What's Been Catching Our Eye

Bank Rate

Despite the fact that the MPC’s decision to raise Bank Rate (to ¾% from the previous ½%) was a unanimous one, it must have been a close call. The case can be made of course, and as ever the Bank’s analysis in the Monetary Policy Summary and the associated Inflation Report is a professional job. But the arguments used to justify the move are far from overwhelmingly convincing. Growth has picked up in the second quarter from a poor first quarter. GDP growth in Q1 was 0.2% on the quarter and with Q2 data pending, the betting is that GDP growth rose to 0.4%. So reasonable growth, but not racing away.

The Bank had hoped there would be a “rotation” of GDP growth away from consumer spending towards improving net trade and investment. This has not happened and the bounce in GDP growth in Q2 was yet again consumer driven – helped by the exceptionally good weather, a royal wedding and the World Cup. With consumer finances still under pressure the pick-up in consumer spending appears to have been largely driven by higher unsecured (i.e. credit card) borrowing. Inflation is above target (at 2.4%) and may rise marginally short term due to the higher oil price but it is well below the levels of a year or so ago and the trend is generally thought to be downwards.

So why an increase in Bank Rate at a time which is generally perceived to be a very uncertain one for the obvious reasons? At the heart of the Bank’s analysis is the view that the trend sustainable growth rate in the UK at the moment is 1½%. The Bank’s forecast for the next couple of years is that GDP growth will be a steady 1¾%. So growth just above trend. Given the perception of little spare capacity in the economy, with the labour market at full employment, there is likely to be some pressure on costs and prices that you would usually expect given above-trend growth. Not really apparent yet, with the pace of growth of average earnings about where it was a couple of years ago, despite reports of labour shortages and difficulties in recruitment and retention in some businesses. If there are any signs of upward pressure on wage settlements currently it is coming from the public sector, given the lifting of the wage cap. So a rate rise justified on a marginal call – that growth might be ¼% above the sustainable trend. Anyone familiar with the margins of error in economic forecasting will realise this is a fine judgement.

Perhaps to understand the Bank’s thinking you need to take a longer-term perspective. The response to the financial crisis of 2008/09 was (in the UK and elsewhere) to embark upon an unprecedentedly unusual policy stance. Interest rates close to zero and massive quantitative easing. This was thought at the time to be a temporary response to a crisis. Now, ten years on, the position has not changed very much. It is a policy stance which leaves central bankers (here and elsewhere) deeply uneasy. The MPC have long wished to get back to a more “normal” stance of monetary policy. Attempts to raise rates in the past have been frustrated when economic conditions took a turn for the worse. Now, a window of opportunity, and the Bank took its chance. It is hoped that the “normalisation” process will gently continue, with roughly two more ¼% Bank Rate increases in the next two years if all goes well, and especially if the economy delivers 1¾% GDP growth.

One last point. The Bank is assuming an “orderly” Brexit, without going into details about what it means by this, sensibly avoiding the very fraught political debate. But the economic environment could get much more uncertain later this year, with crunch EU meetings pending, and again into next year as we go through the formal exit. If you want to get rates up, better to do it now rather than wait even for a few months, given who knows what the circumstances will be then. The elusive window of opportunity the Bank has been waiting for might soon have disappeared.

By John Shepperd; Economics Adviser to Butler Toll Asset Management

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