July 2007. Roger Federer won Wimbledon for the fifth time and Venus Williams the ladies’ title. Gordon Brown had only just become prime minister and spent much of the month dealing with devastating summer floods. The European Union nominated Dominique Strauss-Kahn as managing director of the International Monetary Fund, a nomination that did not end well.
It was also the last time interest rates in Britain rose. In July 2007, paradoxically just as the global financial crisis was rumbling into view, the Bank of England’s monetary policy committee (MPC) raised rates from 5.5% to 5.75%.
I would encourage you to savour that sentence for a moment, not only because it is so long since it happened but also because the level of rates at the time: 5.75% is so far away from the current Bank benchmark of 0.5% as to look like another world.
At the time, an rate rise was unremarkable, as was a 5%-plus rate. The MPC had raised rates in May, as it had on many occasions – 18 in all interspersed with cuts – since independence in 1997.
But that, as things stand, was that. The Bank raised rates repeatedly in its first decade of independence. For reasons we know only too well, it has not done so at all in the first seven years of its second decade. When will it do so?
Before answering that let me remind you what an unusual period we are in. Until it was cut to the current 0.5% in March 2009, Bank rate had never been as low as this, in a history stretching back to 1694, when the Old Lady of Threadneedle Street was a bouncing baby girl. The previous low was 2%. In 1694, by the way, Bank rate was 6%.
This is now, in addition, the longest period of unchanged rates since the Depression and Second World War. Then, there was a cut to 2% in 1931 and no increase until 1951.
There is another exceptional feature, which is that the MPC decided even a prolonged period of 0.5% rates did not provide enough of a monetary stimulus, so it undertook £375bn of purchases of gilts – UK government bonds – in its quantitative easing programme.
The Bank provided some new guidance last week on what it intends to do about that £375bn of gilts, which it still holds. Some will be run down automatically as they mature, though even that process will not begin before interest rates have started to rise.
Large-scale asset sales, and this was new, will not begin until interest rates have reached a level from which they can be “materially cut”. The MPC does not want to get itself into a position in which it sells gilts back to the markets but is forced to buy them back again because the economy weakens. As for the level of interest rates at which they can be materially cut, I judge that to be when Bank rate has reached 2.5% or 3%.
That is also the rate we are being encouraged by the Bank to think of as the new norm, implying it will be well into the Bank’s third decade of independence before we see an official interest rate starting in a 5. Normality is a long way away. For the next few years, on present thinking, we will go no higher than 3.
When will the Bank begin to scale that peak? When, in other words, will rates start to rise? Had you asked me that question a week ago, I would have had no hesitation. In its February inflation report the MPC, and its governor Mark Carney, seemed happy to endorse the market view that the first hike would come next spring. Martin Weale, the most hawkish member of a dovish MPC, said explicitly households and businesses should prepare for higher rates then.
Now, however, a terrible fuzziness has taken over. In presenting the Bank’s May inflation report, Carney was unwilling to endorse any view on rates, let alone the market view of the first hike occurring in a year’s time. Short of a magician-like flurry, producing some white birds from the lining of his jacket and releasing them into the room, he could not have been more dovish.
It was not just his sporting analogy – a reference to the World Cup – that this seemed like a return to the Mervyn King era. We appear to have returned to the pre forward guidance period in which the MPC takes one meeting at a time and the only determinant of when it decides to raise rates will be the data.
I still think rates will start to rise in roughly a year’s time but why the fuzziness? There are three possibilities.
One is that, with the MPC in a state of flux, Carney cannot pre-judge what his new colleagues will decide. Soon Spencer Dale, the Bank’s chief economist, Charlie Bean, deputy governor, and Paul Fisher, executive director for financial markets, will leave the MPC.
They will be replaced by Andy Haldane, Minouche Shafik and Kristin Forbes, an American professor of economics at the Massachusetts Institute of Technology, once a member of George W Bush’s Council of Economic Advisers. Haldane has made many speeches, though not on monetary policy. The others are unknown quantities.
A second reason may be that, the closer a rate rise gets, the less precise the Bank will want to be. If a hike were seen in the markets as set in stone and for some reason did not happen, the Bank could lose credibility.
Related to this, had the Bank provided an endorsement of a rate rise in the early part of next year then, markets being markets, it would not have rested there. Any strong data would be interpreted as bringing the expected hike forward into this year; speculation I judge the Bank does not want.
Finally, it may be that Carney has not quite given up on his initial forward guidance of last summer, which you will remember signalled that no hike was likely until 2016. The key question for the Bank is how soon it acts before spare capacity in the economy – which it estimates at 1% to 1.5% of gross domestic product – will be used up.
It thinks it will take three years for that to happen, but will not wait until that point before hiking rates. The question is how long in advance it decides to pull the trigger.
As I say, I think the first move will be in roughly a year, and the Bank’s own forecasts imply that. But instead of clear guidance, we now have a rather fuzzy interest rate outlook. Forward guidance was meant to provide clarity on interest rates to households and businesses. The current guidance is anything but clear.
This piece is cross-posted from EconomicsUK with permission.