By Conor Lambe, Economist at Danske Bank
The months of flat, or sometimes falling prices, observed in 2015 are now well and truly behind us. Last week, it was announced that consumer prices in the UK increased over the year to June by 2.6 per cent. This was lower than the 2.9 per cent observed in May, mainly due to fuel prices falling over the month, but June still marked the fifth consecutive month of above target inflation.
Looking at annual changes, prices increased across all 12 product categories that contribute to the headline inflation rate. Prices increased the most for alcoholic beverages & tobacco, education and transport. The lowest price rises were for communication, recreation & culture and miscellaneous goods and services. June was the fourth month in a row that prices increased across all the spending categories.
Given the broad-based price rises that have gripped the economy, the debate around when to begin increasing interest rates has picked up over the last few weeks. At its June meeting, the Monetary Policy Committee (MPC) maintained the Bank of England’s base rate at 0.25 per cent, but the 5-3 majority in favour of keeping rates unchanged was unexpectedly close.
Then in the weeks following the last MPC meeting, Bank of England policymakers made a number of statements regarding interest rates. Mark Carney, the Governor of the Bank of England, aired his view that it’s not the right time to put rates up. Ben Broadbent, the Deputy Governor for Monetary Policy, also signalled that he wasn’t yet prepared to vote for a rate rise. However, Andy Haldane, the Bank’s Chief Economist, remarked that it might be appropriate to tighten monetary policy later this year.
There are a number of factors that would support a rise in interest rates. The Bank of England’s main goal is to maintain inflation at around 2 per cent over the medium term. Inflation is currently above the target rate and future rises towards, and possibly even higher than, 3 per cent are still a possibility. Therefore, starting to put rates up now could be viewed as a necessary step if the Bank is to achieve its main policy objective.
The timeframe for monetary policy normalisation is another point worth considering. Given that interest rates have been close to zero for so long, it would be best to avoid a sharp, fast rise in rates. Rather, policymakers would likely prefer to raise rates gradually and give households and businesses time to adjust to the change in the interest rate environment. After years of low rates, there is an argument that policy should start to be tightened now to allow time for this phased return to higher interest rates. This would avoid the potential risk of having to put rates up too quickly, which could have adverse economic consequences, if at some stage over the next few years inflation unexpectedly rises even higher.
There are also a number of arguments in favour of keeping interest rates at current levels. The latest data shows that the rate of nominal wage growth in Great Britain over the year to March-May 2017 was 2 per cent. This is below the rate at which prices are increasing. So in real terms, or taking account of inflation, wages are actually decreasing.
Higher prices and the accompanying negative real wage growth are squeezing UK consumers. In the first quarter of this year household spending growth was below its long-term trend, and this had an impact on overall economic growth. In quarter-on-quarter terms, real GDP grew by just 0.2 per cent. If the MPC were to put interest rates up, there is a risk that consumer spending growth could fall even further and lead to a more severe slowdown in economic growth.
It is also worth remembering that the high rate of consumer price inflation in the UK is mainly a result of the weaker sterling following last year’s EU referendum. The sterling effective exchange rate index, which takes account of the amount of trade the UK does with different countries, was around 9 per cent lower in June 2017 than it was a year previously. So it’s not the case that Bank of England policymakers need to act to dampen excess demand in the economy – as the points above on consumer spending and GDP growth make clear.
Then there’s Brexit. Negotiations are underway but there still seems to be a lack of agreement on the UK side as to what type of Brexit to pursue. This lack of clarity is not helpful for businesses who are starting to plan for the next few years, and I suspect there will be a number of twists and turns as we head towards the anticipated Brexit date of March 2019. Given the impact that this uncertainty is already having, and will continue to have on the economy, an interest rate rise could be viewed as an additional challenge for households and businesses at a time when challenges are in no short supply.
Over the next few weeks, there are a number of events that will likely provide some more clues as to the future path of UK interest rates. Tomorrow, the ONS will publish the preliminary estimate of economic growth in the second quarter of 2017. Then next week, the MPC will meet again and the Bank of England will publish its next Inflation Report. And on 15th August, we’ll get inflation data for July.
However given the fall in inflation announced last week, and more importantly, the strength of the arguments in favour of keeping rates unchanged, I don’t think that we will see interest rates rise before the end of this year.
This article was published in The Irish News on 25th July 2017.