Tightening at Threadneedle Street

November 13, 2017

 

 On November 2nd, Mark Carney, Governor of the Bank of England (BoE), announced a move that was widely anticipated : the rise in key interest rates by a quarter point, from 0.25% to 0.50%. In fact, shifts in monetary policy have been quite trendy this year, starting with the Federal Reserve (Fed) in March. Indeed, Janet Yellen, the Chair of the Board of Governors of the Fed, decided not only once but twice this year to raise the Federal Funds Rate – which has now reached 1.25% in. Likewise, the European Central Bank (ECB) has decided to slowly reduce its quantitative easing programme that was implemented in March 2015 - an unconventional monetary policy that consists in facilitating loans and investment by buying or selling government bonds and increasing liquidity. Indeed, on October 26th, Mario Draghi, the ECB’s Governor, announced that the ECB will only buy 30 billion euros worth a month compared to 60 billion previously.

        

So why has the BoE’s Monetary Policy Committee suddenly decided to shift its stance, given that it had not changed interest rates since 2007?

 

Undoubtedly, the signal sent today by the BoE is strong. According to economic theory, one of the most significant transmission channels of monetary policy is the signalling channel. That means that economic actors - including banks, firms, and households - are extremely sensitive to a central bank’s announcement and respond to it by changing their consumption and investment habits: they adopt forward looking behaviour. Indeed, they anticipate a change in their future revenues when taking into account the information given in the announcement. Likewise, by raising interest rates, the BoE has an impact on inflation expectations and in fine - in accordance with the self-fulfilling prophecy theory applied to Economics - the central bank has an impact on the level of inflation itself.

 

Given that the United Kingdom’s inflation rate is currently at 3%, the BoE hopes that this announcement will stabilise inflation around its 2% target. Indeed, the Monetary Policy Committee believes that economic growth in the UK is currently at its speed limit : the unemployment rate is at its lowest since 1975. Therefore, according to the Phillips curve that describes an inverse relation between the rate of unemployment and the rate of inflation, workers have more power to ask for an increase in wages, and this rise in wages contributes to a rise in prices, creating high inflationary pressures. Also, by increasing interest rates, the BoE contributes to a strengthening pound: the theory stating that higher interest rates will attract investors towards UK assets and hence increase demand for the pound.

        

However, Threadneedle Street decided on such a policy at a time when the future of the UK’s economy is somewhat blurred. This can be worrying: first of all, when interest rates increase, it becomes more difficult for households to pay back their mortgages. According to the accountancy firm Moore Stephens, households will have to face £1.8 billion additional interest payments as a consequence of the rise in key interest rates decided by the BoE. Consequently, these households will have less money to spend on consumption. The latter being a key variable of aggregate demand, this decrease in consumption has a negative impact on economic growth. Therefore, it is crucial for the BoE to take into account the importance of the output gap, that is to say the difference between actual Gross Domestic Product (GDP) and potential GDP. Indeed, most economists agree over the fact that the potential growth of the UK has fallen: should the BoE be wrong in the raise in wages it is forecasting, this increase in key interest rates could be dramatic for the UK’s economy. Hence, the BoE is being cautious in its shift in monetary policy as it has announced a gradual increase in interest rates. Indeed, Threadneedle Street will keep a close eye on the evolution of wages in the UK in the months to come.

 

Thus, although the decision to increase interest rates was not a surprise, the impact of such a measure on the UK’s future economic growth remains unclear : it will be up to the BoE to make sure that the payoff of this increase in interest rates outweighs its cost in order to secure economic growth both in the immediate term and the long run.

 

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