|Ross Walker, Senior UK Economist at RBS|
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. That gave the Banks November Inflation Report added importance.Not only did the report bring forward the Banks forecast of when unemployment would fall to 7 per cent, it also sharply increased the probability that this threshold might be reached earlier than its new Q3 2015 estimate. But despite this surprisingly hawkish outlook, the Banks forecasts still look too pessimistic. A faster decline in unemployment, alongside above-target inflation, will probably force an earlier response than the Bank have so far forecast. In reality, unemployment looks more likely to reach 7 per cent by around Q1 2015. That would open the door for a first rate rise in Q3 2015, or possibly even Q2 2015. 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 currently hold debt equivalent to 136 per cent of their disposable income. That is down from 163 per cent in 2008, but well short of the 115 per cent or so that represents a sustainable level. A resurgence in the housing market on the back of continued record-low rates could once again fuel an unsustainable build up in debt. Second, there is a risk that inflation will gallop further past the Banks 2 per cent target if the economy is not tethered by higher rates. With the MPC forecasting faster growth (and on the assumption that interest rates remain at current levels) the risks are skewed towards inflation continuing to overshoot. The Bank may succeed but its inflation record is patchy missing the 2 per cent target for 57 out of 69 months since the start of 2008. But does overshooting inflation matter? The present situation is hardly a return to the chaos of the 1970s or the volatility of the 1980s. Financial markets currently seem to be giving the UK a pass perhaps acknowledging that a modest overshoot is a price worth paying to support demand and recognising the UKs relative safe haven status. It could start to matter if, for example, greater stability in the eurozone started to make risk-averse investors look afresh at the Continent. In that scenario, the UK runsthe risk that investors demand a higher premium to protect themselves against an inflation overshoot. Higher rates would have an inevitable impact on growth. The bloated state of the UKs debt stock is affordable only because of exceptionally low rates. It remains a significant vulnerability when 70 per cent of the UKs GBP1.3 trillion mortgage loan book is tied to floating rates. Under the Banks old remit, some members of the MPC might already have voted for rate rises at this relatively early stage in the recovery. Minutes of the October meeting showed all nine members voted to hold rates. With a mandate more like the Feds than the ECBs orthodox inflation-targeting regime and with fewer hawks in their number the committees dovish bias looks firmly set. When interest rates do start to rise again whether in 2015 or 2016 it is relatively likely the committee will take an equally cautious approach to the pace at which stimulus is withdrawn. The new policy of forward guidance seems less designed to clarify the Banks possible reaction to inflation and more about allowing dovish policy while maintaining some credibility as an inflation-fighting force. 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 danger that aggressive tightening could heap financial stress on Britains highly indebted households. Fortunately, the fact that such a high proportion of mortgages are variable means that even modest changes in the bank rate should quickly feed through into higher mortgage rates. The MPC might not need to get aggressive to dampen consumer demand. Rates will probably rise to around 3.5 per cent by early 2020 (for example, raising rates 0.25 per cent for six consecutive quarters then slowing to six quarter-point increases in four half-yearly steps). There is a risk the Bank might have to raise rates more rapidly if, for example, inflation remained stubbornly high or the UK was sucked into a currency crisis. Rates at around 5 per cent by 2020 would propel debt servicing costs to levels last seen in 2007, when housing repossessions ran at three times todays rate. It now seems that the greater macroeconomic risk is not the MPC tightening monetary policy too abruptly, but too gently leading to a larger and more prolonged overshoot of inflation. If interest rate rises did soon lead to a sharp increase in households struggling to service debts, the MPCs most likely response would be to halt tightening, even with above-target inflation. Alternatively, higher interest rates might sap activity and stubborn inflation erode spending power, but without triggering mass defaults, arrears and repossessions. Either way the risks from British households failure to de-leverage appear to be increasing.
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