A new beginning for UK interest rates | KPMG | UK

A new beginning for UK interest rates

A new beginning for UK interest rates

Is now the right time for the Bank of England to begin tightening monetary policy?

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By the time the Bank of England’s Monetary Policy Committee (MPC) finalises its meeting on 2 November, it will be nearly 10 years and four months since it last raised interest rates in the UK.

Whether to raise interest rates to 0.5 percent is not an easy decision. On the one hand, inflation at 3 percent is well above the Bank of England’s (BoE) 2 percent target, and it could take some time before it settles back down. The main cause of the spike in inflation has been the fall in exchange rate following the EU referendum result, which by now has largely passed through to prices, but the BoE will also be concerned about the tightness of the labour market and potential ‘second-round effects’.

At 4.3 percent, unemployment is approaching the bottom end of the MPC’s estimated range for the equilibrium rate of unemployment, meaning concerns over possible inflationary pressures emerging as a result of the tight labour market could ride high.

So far, wage growth has been remarkably restrained. Uncertainty about the economic outlook and poor productivity performance may be behind that, and the expectation is that both will continue to play a part in the short term, making wages less likely to rise significantly and putting less pressure on the MPC to act.
On the other hand, the longer the MPC waits the more painful an eventual rise will be. The BoE is right to worry about the accumulation of consumer debt, which reached £200bn in June 2017 - almost as high as the £208bn peak in September 2008 before the financial crisis triggered a moderation.

A decade of no rates rises has made many households complacent about the prospects of higher interest rates when considering their finances, and there’s a whole new generation of borrowers who have never experienced a rate increase, with this group potentially representing over 20 percent of all mortgage holders in the UK currently.

This means that even a small change in rates could have a significant impact on borrowers, but it also means that embarking on a course of rate rises now could serve as an important signal to both consumers and businesses that they should take the prospects of rising rates more seriously in their financial planning.

The MPC will be aware that falling real wages are already squeezing consumers and impacting spending, and may be worried that a rise now would prove a blow too far. Continued uncertainty about the progress of Brexit talks is also making businesses reluctant to invest. The BoE may therefore decide it is best to wait until next year when more clarity could see renewed investment momentum in the UK.

Whatever the outcome next week, households and businesses alike would be wise to prepare for the start of a gradual rise in UK interest rates. It is unlikely that the BoE will wait much longer, and it is unwise for the MPC to do so given the level of debt in the economy and the distortions such a prolonged period of low rates create.

Long suffering savers may rejoice in such news, but banks and insurers should also beware the potential impact on their liabilities as customers feel the strain.

Above all, we should all take heart from the fact that, despite current uncertainties and the recent more challenging economic environment, the UK economy is judged as sufficiently strong to leave the monetary policy intensive care unit and is ready to embark on the long road to monetary normalisation.

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