Ian McCafferty: Bank of England MPC hawk lists four reasons he votes for an interest rate-rise

Jessica Morris
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Ian McCafferty wants the Bank of England to raise interest rates. (Source: Getty)

One of the Bank of England monetary policy committee's two resident hawks, Ian McCafferty, has explained his reasoning behind voting for an interest rate rise "sooner rather than later".

During a speech at a breakfast organised by the Institute of Directors this morning, McCafferty explained why he's voted for voting for an interest rate rise for the past three months. However, Bank of England Governor Mark Carney and the rest of the MPC's 12 members has voted in favour of holding them at the record low of 0.5 per cent.

"Balance of risks"

McCafferty voiced concern about how current risks to the economy are being weighed. Failing to judge them correctly could jeopardise the bank's future inflation targets, he said.

If either the current level of slack is smaller, or the pace of future absorption somewhat faster than envisaged, then, given the lags involved, there is a risk that pay and unit cost growth will begin to rise fast than is consistent with our inflation target.

It takes some 18 to 24 months for the full effects of any change in interest rates to feed through to the economy.

So I am thinking not only about the coming wage round in 2015 but also the wage round in 2016 when considering inflationary pressures over the policy horizon.

Economic growth

The Bank of England has held interest rates at a record low of 0.5 per cent for over five years now.

The economy is now starting to return to more normal growth rates, and by keeping interest rates so low, the bank is essentially pumping in more monetary stimulus than it intends to.

He said:

I have been concerned that, at a time in which the economy has been growing consistently above its likely potential, we remain sensitive to the effective level of stimulus that we are providing.

It is likely that as the headwinds weighing on the economy have abated, it has started to return towards more normal levels. If the neutral rate is rising, keeping Bank Rate constant effectively imparts additional monetary stimulus.

"Gradual and limited"

Raising interest rates sooner rather than later will give the central bank enough time to make small, incremental increases in future.

This is important because it will give households and businesses more time to adjust to the changes. The Bank of England will also be able to observe the effects of these changes, meaning they are more likely to deliver better policy responses.

He said:

To me, this gradualism is a critical element of our policy armoury.

It minimises the disruption to consumers and businesses inherent in the normalisation of monetary policy, as well as allowing us to assess the impact of a policy change after a long period of stability - whether, for example, consumers are more sensitive to changes in interest rates currently they were before the financial crisis.

"Risk appetite"

A blanket of monetary stimulus has subdued markets, putting a ceiling on the returns investors can get from traditional investments such as stocks and government bonds.

This has pushed the yield-hungry towards riskier assets, such as "slice and dice" loans which have been blamed for causing the global financial crisis.

However, when thinking about future financial stability, this is potentially dangerous.

He said:

By encouraging investors to increase their exposure to risky assets to receive higher returns, persistently low interest rates can increase the risks to financial stability, potentially intensifying the need for a more dramatic policy response later on.

Although risk appetite has waned over the past few months, the decline of yields on risky corporate bonds during the past couple of years indicates that some search for yield has been taking place.

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