Five key factors that will decide when Bank of England raises interest rates

In a recovery that policymakers find hard to read, rates may, or may not, rise soon, depending on a complex matrix of indicators

It doesn't know when. It doesn't know by how much. And it doesn't know how quickly. But one thing the Bank of England is sure of is that, at some point, interest rates will be raised from 0.5%, their rock-bottom level of the past five-and-a-half years.

Threadneedle Street's governor, Mark Carney, said last week that the UK's economic momentum was looking more assured. The Bank's forecasts, not always 100% reliable in recent years, point to growth this year of 3.5% – the highest since 2003. Back then, official interest rates stood at 3.75% in November and were raised four times – a quarter of a percentage point at a time – during the following year.

Carney's message to Britain's mortgage-payers and businesses is that the era of ultra-low-cost borrowing is coming to an end.

"Interest rates can be expected to increase as the expansion progresses. But, given the broad forces acting on our economy, the normal rates of tomorrow are likely to be lower than those of yesteryear," he said.

So what are these broad forces acting on the economy? And how important will they be in the Bank's decisions?

Issue one: slack

The Bank is interested to know how fast the economy is growing, but it is even more interested in the amount of spare capacity – or "slack" – that is available. So long as there is slack, the UK can continue to grow above its long-term trend rate of approximately 2.5%-2.75% without inflationary pressure mounting. Once the slack is used up, there is the risk that inflation will start rising. The bad news, according to Carney, is that "slack in being used up at a faster pace than we had anticipated"; but the good news is that "there was more slack in the first place". At present, the Bank estimates that slack amounts to 1% of GDP, but Carney will act before all spare capacity disappears.
Importance: high

Issue two: wages

Measuring the amount of spare capacity is an imprecise and difficult science. The Bank thinks most of the economy's slack lies in the labour market, where there are the people who are working fewer hours than they would like, or who want a job but cannot find one. It has been surprised at the weakness of wage growth over the past year, a period that has seen employment increase by more than 800,000. It is not sure whether the lack of any upward pressure on wages, reflected in the 0.6% increase in annual average earnings excluding bonuses, is temporary or structural. If the former, average earnings will start to rise over the coming months, triggering dearer borrowing. Lena Komileva, chief economist at analyst G+ Economics, says the Bank's "monetary arithmetic is not about GDP strength, but … uncertainty about when UK wages will recover".
Importance: critical

Issue three: indebtedness

Given Britain's propensity for housing booms and busts in the past 40 years, the Bank is keeping a wary eye on the state of the property market. For the time being, though, the emphasis is on the Bank's financial policy committee to use tailored policies to control mortgage lending and borrowing, with the "big gun" of higher interest rates being seen as a last resort. What does worry the Bank is that many borrowers would find it hard to make ends meet in the event of even fairly modest increases in interest rates. The Resolution Foundation thinktank estimates that the number of households struggling to pay the mortgage would double to 2.3m by 2018 if the Bank raised rates from 0.5% to just under 3%.

Indebtedness is more likely, however, to have an impact on the eventual level at which rates will settle than on whether they will go up at all – particularly since the Bank believes lenders will absorb most of the initial increases in their profit margins.
Importance: medium

Issue four: sterling

The level of the pound matters to the Bank. If sterling is going up against other currencies, imports become cheaper and that pushes down inflation, but it hurts exports by making them dearer. Conversely, a falling pound drives up prices but makes UK exports cheaper abroad.

Over the past year, the pound has appreciated by 14% against a basket of world currencies, but the full effects of this have not yet been felt. A sharp fall in sterling would lead to the Bank revising up its forecasts for inflation and make an interest-rate move more likely. With the eurozone struggling, however, this does not appear an immediate threat.
Importance: low

Issue five: events overseas

The past few weeks have seen a marked increase in so-called geopolitical risk. Fears of a conflict between Russia and Ukraine are already having an impact on business confidence in Germany, while events in Gaza and Iraq have added to concerns about supplies of energy. But for the time being, the biggest concern for the Bank is the weakness of the eurozone, where growth was slowing to a standstill in the second quarter even before events took a turn for the worse in Ukraine.
Importance: medium, potentially high

Of the five factors listed above, the final three point to the Bank continuing to adopt a cautious approach. The City considered last week's inflation report to be less hawkish than the Bank's previous health check on the economy in May. Peter Dixon at Commerzbank said: "We get the sense there is little urgency to pull the trigger on interest rates any time soon."

As a result, financial markets now believes the first increase in interest rates will be in the first three months of 2015 rather than in the final quarter of 2014. That view could change swiftly, however, if the release of the minutes taken at the August meeting of the Bank's monetary policy committee show there is no longer unanimity about keeping rates at 0.5%.

Moreover, wages hold the key to what will happen to borrowing costs. If it becomes clear that the weakness of earnings is simply the result of it taking time for pay to respond to shrinking dole queues, the Bank will not wait long before pulling the interest-rate trigger.


Larry Elliott

The GuardianTramp

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