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Interest rates cannot stay at such low levels

ALL this discussion of what is going to happen with regard to UK interest rates does bring back memories of that time - what feels like aeons ago - when rates did vary, rather than being stuck seemingly indefinitely as close to zero as feasible.

CONUNDRUM: Bank of England Governor Mark Carney knows now is not the right time for an interest rate rise. Picture: Getty
CONUNDRUM: Bank of England Governor Mark Carney knows now is not the right time for an interest rate rise. Picture: Getty

In a sense, this transition back to pre-recession days is good news, in that it signals a belief that growth is back on the agenda on a continuing basis. At the same time, there must be concerns as to whether such growth is balanced and thereby sustainable; and also as to whether - if there are burgeoning fears about incipient inflation - any early rise in interest rates is the right answer to tackling the underlying root cause of inflation risk.

Let us start with the state of our economy. Regular readers of this column will know that I am not, as yet, persuaded that a balanced recovery is under way. The estimate of UK GDP growth in Q1 has been revised upwards, and there are hints that business investment has edged up but it is household consumption that provides the overwhelming majority of the fuel for growth.

This has come during a period when real wages have been declining, so increases in consumption have been the result of enhanced borrowing rather than higher incomes. This is dangerous. Excessive household debt was a major cause of the crash of 2008. At the same time, exports continue to disappoint. Also, the growth in investment could be temporary, given that bank lending to the non-financial corporate sector actually declined by nearly £10 billion in Q1.

Meantime, inflation remains below the 2% target, while the Bank of England central forecast is for this to remain the case for at least the next two years. Nevertheless, the muttering about rising interest rates 'ere too long continues. In the ever-cautious words printed in the minutes of the Monetary Policy Committee meetings: "For some members the monetary policy decision was becoming more balanced."

Martin Weale, labelled a hawk on the MPC, has gone further, indicating that he has to ask himself: "Where do I think the interest rate should be at the moment?" He relates this to his view that the extent of slack in the economy - in economists' jargon the output gap - has declined to a worryingly low level. All this suggests that his view of inflation prospects is less relaxed than that of the majority of his colleagues.

The basic interest rate set by the MPC has remained at 0.5% since 2009. Rates remain at historically low levels in all major economies. If UK rates were to increase this autumn, even by an initial quarter of one per cent, then our central bank would be the first to have taken action. I see no justification, based upon our growth prospects, the inflation risk (domestic and imported), or the available capacity in our economy, for the UK being the first to take pre-emptive action. But I do see risks if that were to happen.

The problem is that there is another major issue around our economy which is causing anxiety and for which a rise in interest rates might just be seen as a simple solution. That issue is, of course, our housing market. Perhaps I should clarify: it is not "our" - as in Scotland - housing market (and certainly not in Midlothian, where I reside). It is in the housing market in London and the south-east where worrying levels of inflation can be found (as compared to a 10% decline in Midlothian!).

There is no way a rise in over-arching interest rates should be seen even as a partial solution to a housing bubble in one part of the UK. The result would be major financial strains for some households and probably continuing rapid house price inflation in the south-east. To be fair, this is not an argument that Martin Weale has been using nor has there been any such suggestion in the MPC minutes or from statements from Bank of England Governor Mark Carney.

One sensible policy option for the housing problem, as suggested by Nigel Lawson, would be to reduce some of the demand pressure by banning the Help-to-Buy scheme from the over-heating regions and also to limit this scheme to lower-value properties - say, a maximum of £300,000 rather than the present £600,000 in England.

Building more houses is a longer-term solution, but ceasing to fan the flames through inappropriate subsidies would at least be a rational and targeted response.

In sum then, while inflation is below target and the inflation outlook remains benign, while we really need a pick-up in investment and while sustainable growth is not secure, now is not the time for a rate rise to be even considered. Governor Carney appears to fully appreciate this and we must hope that he can contain Mr Weale and any fellow hawks for a good while yet. Maybe rates will have to rise later in 2015, but even then it should be a gentle process and in harmony at least with the Federal Reserve and US rates.

Nevertheless, any sensible business or household should be starting to think what slightly higher rates might mean for them and considering what action by way of response might make sense. Rates cannot stay at such ultra-low levels indefinitely.

Jeremy Peat is an adviser to Strathclyde University International Public Policy Institute

Contextual targeting label: 
Finance

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