Why UK interest rates could soon rise

As the world was still reeling from the effects of the great financial crisis 10 years ago, the Bank of England decreased UK bank rate to its lowest-ever level of 0.5%.

That’s where it stayed until the post-Brexit vote emergency cut.

And exactly a decade has passed since our government’s backing for the British banking system persuaded Standard & Poor’s to lower its UK sovereign debt outlook from ‘stable’ to ‘negative’.

Since the crisis, Britain’s economy has of course recovered, even if Brexit has added more complications. Yet UK bank rate still stands at a mere 0.75%, while 10-year gilts are only yielding a miniscule return (by past standards) of around 1.1%.

But this could soon change…

QE too

Cash savers hardly need reminding about this.

Compared with history, UK policy interest rates, i.e. those set by the Bank of England, are incredibly depressed. And Standard & Poor’s warnings have done nothing to deter investors from piling into gilts. Quite the opposite, in fact.

Granted, ultra-low gilt yields are more a function of QE – BoE bond buying to suppress long-term yields – than a sign of the rating agencies’ forecasting inabilities.

But a full decade after the great financial crisis, surely we’d expect by now to see higher returns on cash and gilts than those that are currently available?

Back in the good old days before QE was even a twinkle in the eyes of central bankers, interest rates were expected to be broadly equal to the nominal economic expansion rate (real growth + consumer price inflation).

The difference between policy rates and 10-year gilt yields was a function of longer-term nominal GDP forecasts compared with current growth estimates.

Here’s an example of what I mean.

UK real GDP growth is currently around 1.5% a year. The exact level depends on whom you talk to, and there’s that Brexit uncertainty in the background.

But let’s use 1.5% for simplicity’s sake.

Britain’s consumer price inflation has just hit 2.1%, according to the latest official numbers. Again, to keep things simple, we’ll use a 2% round number.

Add 1.5% for growth and we’ve got a 3.5% total. Which compares with the above-stated bank rate of 0.75% and long gilts at 1.1%.

In anyone’s language, that’s a major disconnect.

Yet it’s been in existence for so long, financial markets have become used to it.

It’s now the new normal.

The Bank wants to raise rates

Now I admit I’ve not always been too complimentary about the Bank of England. It’s often well wide of the mark in making its forecasts. Yet to be fair to the denizens of Threadneedle St, the Bank’s Monetary Policy Committee’s (MPC) has recently been warning about the need for more interest rate hikes than the market expects.

Sure, either another Brexit delay or else a ‘no deal’ outcome would be likely to stop UK borrowing costs rising for several months if not years. Yet when the divorce uncertainty fades, I believe that the MPC could act fast. And it could work to a similar formula to the past, using a policy guide such as the Taylor Rule as outlined by the eponymous economist.

John Taylor’s original rule suggested that central banks should set interest rates based on a real neutral level of 2% plus the current rate of inflation relative to the 2% target and the output gap (that’s the deviation of GDP growth from potential).

Please excuse the jargon. But you don’t need to be an econometrician to see that on this basis, bank rate would be much higher than it is today.

As ever, though, it’s not that simple.

“The rule is heavily influenced by what the neutral rate is assumed to be, and almost everyone agrees that the neutral real interest rate is considerably lower now than in the 1990s when Taylor first estimated his rule”, notes Capital Economics.

“We have tweaked the Taylor Rule to take account of the fall in the neutral interest rate by using a 10-year average of the actual interest rate instead of a constant 2%. In this case, the rule suggests that rates should be lower than 0.75% now. And based on the Bank of England’s forecasts for inflation and the output gap, the rule suggests that rates should be about 1% by the end of 2021, bang in line with what the markets expect.”

But before borrowers relax and savers get further steamed up, note that Bank of England Governor Mark Carney said in the May Inflation Report press conference that less UK uncertainty would push up the neutral rate. In turn this would have consequences for monetary policy.

Here’s Capital Economics again:

”If the neutral rate were to rise to just 1% over the next few years compared to about 0.5% now, plugging the Bank’s forecasts for GDP and inflation into the policy rule suggests that interest rates will have to rise to about 1.25% by end-2021. If we make the same assumption about the neutral rate but plug in our own stronger forecasts for GDP growth and inflation, then the policy rule suggests that rates should rise to around 1.50% by the end of 2021.”

To sum up, then: the Brexit outcome is clearly pivotal for UK interest rates over the next year or more. The more uncertainty there is around, the less likely a rate rise becomes. But the MPC does want rates higher, if only in order that it can cut them again when the next recession hits.

In other words, the longer-term outlook for borrowers could still be darkening while bank depositors have grounds for becoming more bullish. As for the stock market: my instinct is that higher rates at this stage of the cycle could be a negative influence.

But wouldn’t it be great for savers to return to ‘old’ normal interest rates again?

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