THE BANK of England’s revised mandate may push the Monetary Policy Committee (MPC) to leave interest rates on hold for too long, complicating efforts to bring down inflation and household debt to more prudent levels.
Key to the timing of interest rate rises will be unemployment, since the Bank is highly unlikely to hike rates until the jobless rate falls below 7 per cent. And not only did the November Inflation Report bring forward the MPC’s forecast of when unemployment would fall to 7 per cent, it also sharply increased the probability that this threshold is reached earlier than its new third quarter of 2015 central estimate.
Yet despite this surprisingly “hawkish” shift in outlook, the Bank’s forecasts still look too cautious. A faster decline in unemployment, alongside above-target inflation, will probably force an earlier response than the Bank is signalling. Unemployment looks more likely to reach 7 per cent by the first quarter of 2015. That would open the door for a rate rise in the third quarter of that year, or possibly even the second. Yet even this may leave the start of the tightening cycle too late.
First, UK households remain highly leveraged despite progress in reducing the stock of debt relative to disposable income. On average, households hold debt equivalent to 136 per cent of their disposable income – down from 163 per cent in 2008, but short of the 115 per cent or so we believe represents a sustainable level. A resurgence in the housing market on the back of record-low rates and other stimulus could again fuel an unsustainable build up in debt and fundamental capital misallocation.
Second, there is a growing risk that inflation will continue to overshoot its 2 per cent target if the economy is not tethered by higher rates. The Bank’s forecasts may be vindicated, but its inflation record is poor. Consumer price index inflation has been at or below its 2 per cent target for just six months during the past six years – and this against the backdrop of the longest and deepest recession since the Great Depression.
Some question whether overshooting inflation matters. The present situation hardly marks a return to the chaos of the 1970s or the volatility of the 1980s. And financial markets seem to be giving the UK a “pass” – perhaps recognising the UK’s relative safe haven status.
But overshooting inflation does matter. In recent years it has put a significant dent into real-terms consumption and, therefore, GDP growth. Greater stability in the Eurozone is also encouraging risk-averse investors to look afresh at the Continent. In that scenario, the UK risks investors demanding a higher premium to protect themselves against expected inflation overshoots. This would inevitably dampen growth.
Further, UK households’ bloated debt stock is affordable only because of “emergency” monetary policy settings. It remains a significant vulnerability when around 70 per cent of the UK’s £1.3 trillion mortgage loan book is tied to floating rates.
Under the Bank’s old remit, some members of the MPC would probably already be voting for rate rises. But revisions to the policy remit imposed by the Treasury and the Bank’s self-imposed forward guidance framework has resulted in unanimous votes for unchanged policy. With a mandate more akin to the Fed’s than the European Central Bank’s orthodox inflation-targeting regime, the MPC’s reluctance to withdraw stimulus will persist for some time yet.
When interest rates do start to rise again – probably in 2015 – the MPC is likely to maintain this cautious approach to the pace at which stimulus is withdrawn. Forward guidance seems designed less to clarify the Bank’s reaction function and more about allowing more dovish policy in the near-term (while attempting to preserve some medium-term credibility on inflation).
The Bank is conscious that an excessively lax response to recovery would risk further inflation target overshoot. But it is likely to pay more heed to the risk that aggressive tightening could heap financial stress on Britain’s highly indebted households. That such a high proportion of mortgages are variable means that even modest changes in the Bank Rate can be expected to feed rapidly through to higher mortgage rates. The MPC will not need to get aggressive to dampen consumer demand.
Our expectation is for Bank Rate to grind higher, to around 3.5 per cent by early 2020. A return to pre-crisis levels of 5 to 6 per cent seems unlikely given the excessive leverage in the household sector. For rates to have to climb to those levels would require more stubborn inflation – resulting, for example, from a collapse in the currency. This is very much tail-risk territory. Were this to happen, Bank Rate at around 5 per cent would propel debt servicing costs to levels last seen in 2007, when repossessions ran at three times today’s rate.
In short, the main policy risk facing the UK is not the MPC tightening monetary policy too abruptly, but an overly timid withdrawal of stimulus, encouraging an ultimately destabilising build-up of debt.
Ross Walker is UK economist at RBS.