Despite the uncertainty surrounding Brexit, this morning the Bank of England decided to raise UK base rates from 0.50% to 0.75%. This is the first time that the British central bank has put interest rates up to the last crisis level before the reduction in March 2009, when it dropped its base rate from 0.75% to 0.50%. There were no dissents.
The central bank premised its decision on the need to curb persistently high inflation, which has eaten away at British wages since the financial crisis. But with Brexit uncertainty dampening UK growth, this is sure to be a controversial decision, perhaps akin to the ECB’s decision to raise rates in 2011 in the midst of a sovereign debt crisis. Some thoughts below
The urge to normalize policy
The BoE has now joined the Fed in the US and the Bank of Canada in starting the long push toward monetary policy normalization. When thinking of reasons that these central banks are raising rates, one look no further than that term ‘normalization’.
Central banks are under tremendous pressure to move away from an accommodative policy stance because of the duration of the expansion and the probability that we are near the end of the cycle. On the one hand, they are criticized for ‘easy money’ in part because they have rates at or near record lows a full 9 years after the acute phase of the financial crisis has subsided. At the same time, given that this expansion has already been very long, central banks are keenly aware that they lack rate cut ammunition should the economy lapse back into recession.
So, all else equal, they want to normalize. The Fed was first to start the process. And now they have been joined by the Canadians and the British. I expect the ECB to follow suit by ending QE with a prospect of raising rates in 2019. When they do, central banks in Denmark and Switzerland can also ease off the gas. The Bank of Japan will be left as the outlier among major central banks. And, for central bankers, they represent a cautionary tale of the trap a lack of monetary ammunition creates.
This is poor timing, though not as poor as the ECB’s
When the British electorate first voted for Brexit, the shock was palpable and many prognosticators overestimated the economic impact, predicting immediate recession. Nevertheless, the Brexit process has been all-consuming for the UK government, casting a pall over the British economy.
With a ‘no deal’ Brexit potentially looming, people in the UK are talking about stockpiling.
The Brexit secretary has promised, not entirely reassuringly, that there will be “adequate food” whatever happens; the health secretary has said the NHS is preparing to stockpile medicine. Yet it is not clear that enough is being done to honour these pledges. Britain spends some £50bn ($66bn) a year on medicine and non-perishable food from the EU. So stocking up with enough for just a month would cost around £4bn—more than the entire no-deal planning budget of £3bn set aside in November. Nor is there any sign that reserves are being built up. Food and medicine imports have been steady in recent months.
This goes to the mood in Britain. How could the Bank of England justify raising rates in that environment, especially considering inflation-adjusted pay has actually gone up recently after years of sinking. In June, the Guardian was talking about wage increases reducing pressure on the BoE.
The timing is incredibly poor – almost on par with Jean-Claude Trichet’s decision to raise rates in the summer of 2011 as the European sovereign debt crisis ravaged the European periphery.
The economic impact
The UK is less dependent on variable rate mortgages than it was during the house price bust of the 1990s. For example, only 35% of borrowers have a variable rate mortgage now versus double that percentage in 2001. For those on a “tracker mortgage”, an extra 0.25% adds £12 per month to a £100,000 mortgage, £25 onto a £200,000 loan. That’s a decent amount, but doable. The overall impact of the rate rise will be negative though.
As we saw with the US interest rate increases, while banks pass through rate increase to mortgages immediately, they are slow to raise savings rates. According to data at the Guardian, the average savings interest rate on demand deposit at one of the “big five” British banks is 0.23%. Maybe this goes up to 0.3% or 0.4% as a result of the base rate change. The overall impact on personal savings will be minimally positive then.
The language associated with the rate hike suggested that this is a water-testing hike. The BoE is likely on hold through the rest of 2018 as the economy absorbs the hike’s impact and we wait and see how Brexit plays out. From a currency perspective, this should help to put a floor under the Pound, which has been weak.