DESPITE longer term interest rates falling to exceptionally low levels over recent days (in the case of some countries to all-time lows), expectations are for short term official interest rates in the US and the UK to start rising over the coming year.
In the UK, the financial markets are pricing in the first move at the beginning of next year, probably around the time of the Bank of England’s February 2015 forecast update. When the Bank does finally move, it will be the first tightening in monetary policy since the middle of 2007.
The BoE’s governor, Mark Carney, has described any forthcoming tightening in monetary policy as likely to be “gradual”. But what precisely does the Bank mean by this and why the need for gradualism? The markets have interpreted the Bank’s comments to mean, on average, around three 25 basis points moves up in rates per year for both 2015 and 2016. They see the Bank taking until the middle of 2017 to get rates back to 2.5%; looking further down the curve, interest rates are expected to rise to just 3.25% by 2020, with interest rate rises tapering off at that stage.
That would be more than 200 basis points lower than the level of interest rates that persisted in the fifteen-year run-up to the global financial crisis.
Reasons to be careful
There are good reasons for the Bank to be cautious in deciding to lift interest rates. First, we’ve been here before – back at the start of 2011 a third of the nine-strong MPC were voting for higher rates before the euro sovereign crisis hit, which in turn led to a double-dip in GDP (output fell modestly between the end of 2011 and the middle of 2012). There are plenty of global risks that could yet end up materialising and putting the brakes on the UK’s chart-topping recovery.
Indeed, only China and India among the G7 & BRIC economies are growing more rapidly than the UK at the moment, yet the level of UK GDP remains below its pre-recession peak and has performed worse than all of those economies with the sole exception of Italy.
The Bank therefore must be mindful that while the UK is growing strongly, it is doing so from an exceptionally low base. With spare capacity still existing in the economy (the Bank of England estimates it to be between 1% and 1.5% of GDP) this should keep a lid on inflation pressures going forward, thereby buying the Bank some time before the need arises for tighter policy.
The home front
Another reason for the Bank to be cautious in the process of interest rate ‘normalisation’ is the impact it may have on households. Mortgage affordability – how much an average household must pay in terms of annual repayments relative to their incomes – is broadly in line with its average over the past 50 years.
However, this is only the case because interest rates are at more than 300-year lows. Were rates to return quickly to their pre-crisis norms it seems highly likely that house prices would need to correct from their current elevated levels. While the Bank may be relieved to see some of the froth taken out of the housing market (expect financial policy to be used to help the process along in the coming months), it must manage the rise in interest rates carefully to guard against a more pernicious crash.
The housing market looks to be a concern when it comes to the impact of higher interest rates, but there is some good news. During the period of exceptionally low interest rates, households in aggregate took on little extra mortgage debt.
Indeed, over the past five years total household financial liabilities have risen by only modestly more than 1% – or around a quarter of a percent rise per year over that period on average, Contrast this with the average increase of around 10% per year in debt levels during the decade prior to the crisis. Some households will inevitably suffer at the hands of higher interest rates – those who have taken out large debts relative to incomes more recently, for example, particularly as house prices have risen rapidly.
Easy does it
Still, the recently introduced Mortgage Market Review has been crafted to ensure that banks are more careful in reviewing their customers’ ability to repay their loans in the event of higher interest rates or loss of income.
In summary, We expect the Bank of England to begin raising rates in just under a year’s time – immediately after the election in May 2015. We see official rates rising from 0.50% to 1% by the end of 2015, then to 2% by the end of 2016 and to between 3% and 3.50% by the end of 2018. This profile is not that dissimilar to market expectations. Higher interest rates will be needed to keep inflation in check on the assumption that growth continues at recent rates.
But gradualism will be the name of the game, and we can expect the end point for interest rates over the next few years to be notably lower than average interest rates in the run up to the crisis. Our forecasts may even be blown out of the water by some of the many risks facing the world economy. Let us hope not.
George Buckley is chief UK economist at Deutsche Bank
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