Aim to keep borrowing costs low could be thwarted by stronger than expected growth and unusually weak productivity
The Bank of England warned that interest rates might rise as early as next year as its chief economist said Threadneedle Street’s desire to keep borrowing costs low for several years could be thwarted by a combination of stronger than expected growth and unusually weak productivity.
Spencer Dale, one of the nine members of the rate-setting monetary policy committee, said the UK was currently growing at an annual rate of 3-4% and the Bank could not be certain when it might need to tighten policy.
Following guidance issued by the Bank in August, the City is expecting interest rates to remain on hold at their record low of 0.5% until at least 2015. But Dale said in a Guardian interview that in certain circumstances an increase could happen as soon as 2014.
“What we are clear about is what the state of the economy will be like when we raise interest rates. What we are not as clear about is whether that is two years ahead, three years ahead, or one year ahead. But it is clear that we are thinking of years not months,” Dale said.
The Bank said in August that unless there was a risk from inflation or an over-heating property market it would only start thinking about raising interest when unemployment had come down to 7% from 7.7% currently, something it did not expect until 2016. But the recovery in the economy seen since the spring has left many in the City convinced that the Bank will be forced to take action before then.
Dale said that “forward guidance” had been useful in explaining how the Bank was likely to behave, and that he was “nervous that some people may be thinking we are going to raise rates just because we are going to have strong growth”.
“By doing that [forward guidance], we reduce the likelihood that people, when they see a few quarters of strong growth, expect us to raise rates. We have reduced the likelihood of a premature raising of rates.”
But Dale said he could not say for sure how long the period of 0.5% interest rates would last. “The economy looks as if it is growing at something like 3-4% annualised. Bank rate is at 0.5%, something that would have been unthinkable a few years ago. The big message is that monetary policy is going to remain loose for a considerable period of time. I can’t be sure whether that means it will be tightened in 2015 or 2016. It could be 2015. It could be a bit earlier than that or a bit later.”
Asked whether the Bank could raise rates as early as next year, Dale replied: “Conceivably it could be 2014. But it would have to be in a world where you had quite strong growth, perhaps stronger than you have got now, and a recovery in productivity weaker than I would expect.”
Dale said the biggest downside risk to the economy was a renewed crisis in the euro area. “We have seen some of the near term tensions ease, but the fundamental challenges are immense.”
But he added that there was also a chance that the economy would grow far more strongly than currently expected.
“If you take business surveys at face value and base your view of the economy purely on them it would suggest that the economy is growing in at a rate in excess of 4%. We might be misjudging it. It could be that the economy is coming back more quickly than we think.
“I am aiming off of that slightly. I am aware of the fundamental challenges facing our economy. In particular, real incomes remain weak and we are not going to see a strong pick up in consumption until we see that.”
Dale said that the economy was still 3% smaller than at its peak before the deep recession of 2008-09 and that the Bank was alive to the risk that a premature increase in borrowing costs could choke off recovery. He added that if markets failed to get the message and pushed up long-term interest rates to a level that impinged on the recovery, the Bank’s monetary policy committee would act. “The natural thing would be to do more quantitative easing and loosen policy to stimulate the economy.”
Dale said he welcomed the fact that the housing market was recovering, and saw no immediate threat of a bubble. It was “great” for the construction sector that more houses were being built, and the increase in mortgage approvals boosted demand for professional services and led to greater labour mobility. “It is good for consumption, because there is quite strong evidence that when people move home they go out and change the carpets and buy new furniture. We are moving from a housing market in deep freeze to where it is thawing and helping the recovery.”
Dale said that one difference from previous cycles was that there was now a financial policy committee at the Bank of England armed with the tools to tackle any problems from the housing market.
He said “bitter experience” had shown what could happen when the housing market was allowed to overheat. “I don’t think that’s where we are now but are very active to that risk. The Bank as a whole is. The monetary policy committee is. Most importantly, the financial policy committee is.”
Asked if the Bank was being complacent, he replied: “We are not being complacent. We are looking at this very closely.”