Fear, not confidence, could be fuelling first potential rate rise in a decade

by

Source: Getty

Last week’s Q3 economic growth figure of 0.4 per cent saw Sterling shoot up by 1 per cent against both the Dollar and the Euro.

It was a predictable response from currency markets, which bought the Pound in the belief the better than forecast number made an interest rate hike a foregone conclusion.

And markets do now overwhelmingly expect rates to head north. The Pound has risen steadily in the past few days against the Euro, from €1.127 on Friday to €1.142 on Wednesday.

Much of the rise in the Pound is being driven by the fact the Bank hiking rates is seen as a sign of economic confidence.

After all, the prevailing view of the past few years has been that when the economic conditions were right, when the economy was seen as performing strongly, interest rates would begin to normalise to stop inflation from getting out of control.

And this is now happening, right? Wrong.

In reality, economic growth since the recession has been fairly weak. The average rate of growth has been around 2 per cent, while the best economic growth was 3.1 per cent in 2014, the year after Bank Governor Mark Carney launched forward guidance.

In 2013, Mr Carney said interest rates would not rise until unemployment had fallen to 7 per cent or below. By May 2014 the UK unemployment rate was 6.8 per cent. But Mr Carney then said that the recovery “was not secure”. The unemployment rate today stands at 4.3 per cent.

The argument then moved to spare capacity, with Mr Carney blaming Britain’s lack of productivity and anaemic wage rises for not raising interest rates. And then the small matter of Brexit popped up on the radar.

The more worrying prospect is that the first rate hike for a decade may ultimately be driven, not by economic confidence, but by economic pessimism.

Economic Pessimism

To put it another way, the Bank of England is worried that low growth and low wages are here to stay.

After all, in a properly functioning economy an unemployment rate of 4.3 per cent should be driving wage rises ahead of inflation, even if inflation is at 3 per cent.

But as reported earlier this week, Bank of England economists are worried that inflation isn’t just being caused by the depreciation of Sterling after the Brexit vote last year.

Given that there is supposedly no more spare capacity in the economy there should be price pressure as supply can’t keep up with demand both in term of goods and wages.

What the Bank may also be worried about is having nowhere to go with interest rate policy, easily its strongest weapon against a slowdown should economic conditions worsen.

Whether it’s inflation, the economy, spare capacity or Brexit that is worrying the Old Lady of Threadneedle Street the most, the first rate hike is coming. It would be a huge upset if that hike was not today.

Markets will celebrate but, If the Bank of England is acting out of fear, perhaps they shouldn’t.