Next week, policymakers at the Bank of England will publish their latest interest rate decision. Markets had previously been confident in predicting the second rate rise in six months, but a slew of bad economic data and cautious comments from Mark Carney have thrown the move into doubt. The decision will be announced on Thursday 10th May, with many asking of the potential raising of interest rates – will they or won’t they?
Interest rate manipulation is the main conventional monetary policy tool available to the Bank of England. When it increases the interest rate paid on commercial banks’ reserves, the commercial banks in turn increase their customers’ cost of borrowing, and also the interest rates that the banks pay on deposits, as a result dampening demand for new loans. By reducing the interest rate, the cost of borrowing is decreased and so is the incentive to save, which then strengthens demand for new loans.
The Bank’s mandate is to maintain price stability currently defined as an inflation rate of 2% “and subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment”. That means that monetary policy has to be accommodative – lower interest rates to strengthen demand when inflation is below target or the economy is weak, and higher interest rates when inflation is above target.
This is where it gets tricky. Inflation has been above target since February 2017, but that has been largely attributed to external factors such as stronger global growth, higher oil prices, increased exports and higher import prices due to the drop in sterling’s exchange rate with the currencies of the UK’s major trading partners. In addition, the uncertainties that Brexit has cast over the economic outlook meant that the Monetary Policy Committee (MPC), according to its remit, “must balance any trade-off between the speed at which it intends to return inflation sustainably to the target and the support that monetary policy provides to jobs and activity”.
With that in mind, the MPC must judge whether the economy is strong enough to see a rate rise. Until recently the MPC believed that “monetary policy would need to be tightened somewhat earlier and by a somewhat greater extent” as unemployment has been at its lowest since 1975 at 4.2%, which led to a slight growth of pay in response to a tight labour market. However, the latest GDP figures released by the ONS showed that for the first quarter of 2018, growth was marginal at 0.1%.
Another key consideration will be whether the MPC expects inflation to rise above its current level. There are several reasons why this is unlikely. Most factors contributing to the current inflation rate are external, and not due to strong domestic demand, as evidenced by the disappointing growth figures. Wage growth is still poor, with real incomes falling over the most recent three-month period.
Nevertheless, we mustn’t forget that the bank rate has been at 0.5% since March 2009. We are nearing a decade in which monetary policy has been extraordinarily accommodative. This is not normal even though it might feel so. The fact that rates have had to remain so low for such an extended period of time, along with the fact that it is proving so hard to raise them, says a lot about the frail state of the economic recovery since the crisis.