BoE Likely to Decide When To Raise Rates by the End of the Year

A decision about the timing of raising rates will come by the end of the year and will be gradual, BoE Governor Mark Carney signaled during the speech delivered at the Lincoln Cathedral.

Extracts of the Speech by the BoE Governor Mark Carney in Lincoln Cathedral:

In my view, with the healing of the financial sector and the lessening of some of the headwinds facing the economy, that concern has become less pressing with the passage of time.  As I made clear in my first open letter in February, were downside risks to inflation to materialise the MPC could decide either to expand the Asset Purchase Facility or to cut Bank Rate further towards zero from its current level of ½ per cent. In the current circumstances there is no need to wait to raise rates because of a risk management approach and run the risk of inflation overshooting target.

At the same time, the timing and pace of prospective interest rate increases need to be put into perspective.  Headwinds to growth and inflation remain.  Growth in the parts of the global economy that matter most to the UK is running ¾ percentage points below its historic average.  Sterling has appreciated around 18 per cent over the past two years and around 7 per cent since the turn of the year.  This will exert a drag on inflation both through lowering import costs and by lowering world demand for UK goods. UK fiscal policy is about to tighten significantly. The average annual reduction in the cyclically-adjusted budget deficit is projected by the OBR to increase from around ½ per cent of GDP over the past two years to around 1 per cent of GDP over the next two – and the IMF expects the UK to undergo the largest fiscal adjustment of any major advanced economy over the next five years.[30]  

Taken together, these factors suggest that the ‘equilibrium’ real rate of interest – the rate needed to keep the economy operating at potential and inflation on target – which was sharply negative during the crisis, will continue to be lower than on average in the past.  It also seems likely that the equilibrium interest rate will move only slowly back up towards historically more ‘normal’ levels.  Everything else equal, that suggests a prospective tightening cycle that, once it starts, will be longer and shallower than those of the past.  In other words, we expect Bank Rate increases to be gradual, and limited to a level below past averages.

It would not seem unreasonable to me to expect that once normalisation begins, interest rate increases would proceed slowly and rise to a level in the medium term that is perhaps about half as high as historical averages.  In my view, the decision as to when to start such a process of adjustment will likely come into sharper relief around the turn of this year.

BoE Likely to Decide When To Raise Rates by the End of the Year

BoE | Joana Taborda |
7/17/2015 11:21:48 AM