When the Bank of England (BOE) raised interest rates two months ago, it marked the first increase in over ten years and came fifteen months after the bank had cut rates to 0.25% in the aftermath of the EU referendum. The circumstances for why interest rates were cut to historic lows internationally from 2008 onwards are well documented. What is less clear are the exact reasons why the BOE has taken the decision now to begin tightening monetary policy. To acquire a sense of why the bank has embarked on this course, it is necessary to go back the best part of a decade in order to plot the gradual progress of their actions.
In the wake of the ‘great financial crisis‘, a programme of quantitative easing (QE) began in March 2009. Rates were cut to 0.5% (the sixth decrease in six months), and £75 billion of new money was created for the purchase of government bonds. The UK was officially in recession by this point, which began in the third quarter of 2008 and lasted until the fourth quarter of 2009.
Eleven months later, in February 2010, the Bank of England halted QE with £200 billion of stimulus generated so far. This decision came three months before the general election and the subsequent formation of the coalition government between the Conservatives and the Liberal Democrats. In qualifying the suspension of QE, the BOE stated that further asset purchases would be made should the outlook warrant them. At the time, inflation was running at 3%, exceeding the bank’s target of 2%.
It was not until October 2011 that the bank restarted QE by creating a further £75 billion. Fears about rising inflation (now at over 5% and largely put down to higher energy prices) were set aside. Justification for the increased stimulus included slow economic growth and the ensuing Euro Zone crisis – both of which were placing additional strains on the banking system and deemed a threat to the UK’s recovery.
Inflation reached a peak of 5.2% for September 2011, with the retail price index touching 5.6% (the highest it had been since June 1991). In previous communications, the Bank of England had proclaimed that inflation would reach 5% within the same time period. They now expected inflation to fall back once factors such as the recent rise in VAT dropped out of the twelve month comparison. It duly did.
Come November 2011, unemployment had risen to 2.62 million, with 1.02 million of 16-24 year olds out of work (a record number). The overall unemployment rate came to 8.3%. Earnings growth was at 2.2%, almost a full 3% below inflation. All of these statistics were cited by the Bank of England as reasons for maintaining interest rates at 0.5%. As the bank cut its 2011/12 growth outlook to around 1%, BOE chairman at the time, Mervyn King, warned the UK economy could stagnate further. Fresh warnings were also issued on the global economic outlook, which the bank said had begun to worsen.
Conditions were therefore primed for the return of quantitative easing in February 2012, following GDP growth of 1.5% the previous year. The BOE announced another £50 billion on top of the £275 billion already created. Concerns such as a decrease in consumer spending levels and the crisis in the Euro Zone were used to rationalise the decision.
Another round of QE followed in July 2012 to the tune of £50 billion, bringing the total injected so far to £375 billion. UK growth was pronounced as flat; growth in export markets had slowed; the Euro Zone debt crisis weighed on investor confidence; both manufacturing and construction were contracting; the service sector had slowed to an eight month low. All of which the bank used to endorse more QE. With inflation running within the 2.5% – 3% range, the bank declared that without further QE there was a danger that inflation would fall below the international central bank remit of 2%. In the same month, the European Central Bank cut interest rates to 0.75%. Rates in the United States remained at the record lows of 0-0.25% set in December 2008.
Towards the end of 2012 in October, unemployment had dropped to 2.53 million with the unemployment rate also falling to 7.9%. 29.6 million were said to be in some form of employment (whether full or part time), the highest since records began in 1971. In terms of GDP, growth fell to 1.3% with quarters two and four returning negative growth. Combined, these conditions gave the BOE the necessary rationale to keep interest rates on hold.
2013 marked a change of leadership at the Bank of England. After ten years as governor, Mervyn King retired allowing Mark Carney to assume the role. Along with thirteen years service at Goldman Sachs, Carney is a former governor of the Bank of Canada and the current chairman of the Basel-based Financial Stability Board (FSB). Carney is also represented on the board of directors at the Bank for International Settlements. Under his tenure it was seen as likely that he would oversee the BOE’s departure from stimulus measures.
The first major act of the Carney era occurred in August 2013 with the introduction of forward guidance. To summarise, the bank’s monetary policy committee agreed that they would not consider raising interest rates until the rate of unemployment had fallen to 7%. At the time the rate was 7.8%. They judged that unless the margin of slack in the economy had narrowed significantly (slack being a measure of the quantity of unemployed resources), it would not be appropriate to tighten monetary policy. The expectation was that it would take until 2016 to achieve an unemployment level of below 7%.
In November 2013, the bank upgraded its growth forecast from 1.4% to 1.6%. The outlook for growth in 2014 was also raised, to 2.8%. With the economy growing at its fastest rate in six years, the bank publicly recognised the growing possibility that unemployment may fall below 7% much sooner than originally predicted, which would move the bank closer to raising interest rates. Despite that, Mark Carney was of the view that the aftermath of the financial crisis had yet to clear, with economic conditions still some way from being able to normalise. In other words, the bank’s ultra accommodative stance would remain.
A few weeks into 2014, the Bank of England released its February inflation report, which contained an updated version of the bank’s forward guidance issued six months previously. The bank’s monetary policy committee declared that,
Despite the sharp fall in unemployment, there remains scope to absorb spare capacity further before raising Bank Rate.
Unemployment has since fallen sharply as the recovery has gained momentum, and it seems likely that data released in the next few months will show that the 7% threshold has been reached.
A new threshold was not set by the committee. Instead, they communicated their belief that spare capacity in the economy was ‘equivalent to about 1%-1½% of GDP, concentrated in the labour market.‘ They surmised that around half of this slack represented the difference between the ‘current unemployment rate of 7.1% and an estimate of its medium-term equilibrium rate of 6%–6½%.‘
At the time of the inflation report (published on February the 12th), unemployment stood at 7.1% (in the three months to November). In April 2014, the rate dropped below 7% to 6.9%, marking a five year low. What is important to recognise here is that unemployment figures in the UK are published two months behind the current month. The April figures, therefore, covered activity only as far as February. This means that the BOE updated its forward guidance in the same month that unemployment fell below the original threshold of 7%. By doing so, it avoided having to enter into an immediate debate on a prospective rise in interest rates. Coincidence or otherwise, the timing was impeccable.
A month later, and with inflation now below the bank’s 2% target at 1.5%, earnings growth surpassed the rate of inflation for the first time since 2008. However, this did not deter the Bank of England. They continued to insist that the economy was still in a process of recovery, signalling that rates would remain at record lows for the immediate future. The message was clear: there was no need to begin tightening policy until a greater level of slack in the economy had been used up. The expectation now was for unemployment to fall to 6.6% by the end of 2014.
In fact, the 6.6% level was met just one month later in June, prompting Mark Carney to state that a rise in interest rates could now happen ‘sooner than markets currently expect‘. The usual provisos applied, namely there was ‘no pre-set course‘ for rates rising and that more spare capacity would need to be used up first. Now that the bank was no longer operating to a specified unemployment threshold, their definition of ‘spare capacity‘ had become ambiguous. We can only assume that this was by design, in order to give the BOE greater flexibility over the timing of when monetary policy would begin to ‘normalise‘.
Only two months after the bank raised the possibility of a rate hike did they dampen such expectation. The August inflation report took into account the continuing fall in unemployment and the record number of people said to be in work, but the issue now was in how to reconcile this with persistently weak wage growth. To quote Mark Carney directly:
Pay growth has been remarkably weak, even as unemployment has fallen rapidly.
In light of the heightened uncertainty about the current degree of slack, the committee will be placing particular importance on the prospective paths for wages and unit labour costs.
Along with weak wage growth and inflation now running below the bank’s target of 2%, increased geopolitical tensions were cited as a risk to economic stability, as was the tepid recovery in the Euro Zone. Taken together, this further cemented the position of the BOE to keep rates unchanged.
Speaking in September 2014 at the TUC conference in Liverpool, Mark Carney emphasised how wages should begin to rise part way into 2015. Unemployment was forecast to fall to around 5.5% over the next three years. As for a rate rise, it is the same spiel: no pre-set course, with the timing dependent on incoming data.
The end of 2014 saw the BOE send out warnings about low inflation (0.5% in December), at a time when wage growth and GDP was on the rise (GDP growth came to 3.1% in 2014). Members of the MPC felt that for inflation to return to the 2% target, pay growth would have to accelerate. This prompted the bank to raise concerns about the potential for deflation going into 2015.
Carney judged low inflation to be a ‘temporary phenomenon‘ in February 2015, going on record as saying that inflation would return to its 2% target by 2017. Should inflation suffer a sustained fall, however, the bank could cut interest rates down to 0% if required. Although, Carney insisted that the ‘focus of policy is towards tightening‘. In other words, the bank was signalling that it wanted to raise rates but economic and geopolitical conditions were not best placed for this to happen.
Further building on this narrative, Carney went on to say that the fall in inflation was largely down to a drop in oil prices. Speaking to the House of Lords economic affairs committee, Carney said:
The thing that would be extremely foolish would be to try to lean against this oil price fall today [and] try to provide extra stimulus to try to get inflation up at this point in time.
The impact of that extra stimulus …would happen well after the oil price fall had moved through the economy and we would just add unnecessary volatility to inflation. That would be foolish.
A couple of months later, the bank lowered its GDP forecasts. Growth prospects for 2015 were cut by 0.4% to 2.5%. 2016 and 2017 forecasts were also slashed. Yet unemployment was now down to 5.5%, a level that the bank did not publicly expect to materialise until 2017. Inflation was flat at 0%. Wage growth was over 2%. The bank cited how household incomes were being boosted by the drop in food, energy and imported goods prices. It was at this point that the City expected the first rate rise to occur in 2016.
Following the election of a majority Conservative government in May 2015, Mark Carney spoke for the first time about the potential for a referendum on membership of the European Union. A referendum should be held ‘as soon as necessary‘ in order to put pay to rising levels of uncertainty in the business sector. His position on the path of interest rates remained the same, in that the MPC expected rates to begin rising at some stage in the wake of a reduction in spare capacity.
Days after parliament had supported plans to hold a referendum on EU membership, the BOE gave its strongest indication yet that a rate hike was perhaps on the horizon. With inflation hovering around 0%, the UK economy was judged to be performing well, with wage growth above 2% and employment on the rise. Carney told the treasury committee:
The point at which interest rates may begin to rise is moving closer with the performance of the economy, consistent growth above trend, a firming in domestic costs, counterbalanced somewhat by disinflation imported from abroad.
In a speech two days later, Carney emphasised how rates could rise ‘at the turn of the year‘. This was tempered, however, by a warning that unforeseen shocks to the economy could change both the timing and size of any rate hikes.
Once normalisation begins, interest rate increases would proceed slowly and rise to a level in the medium term that is perhaps about half as high as historic averages.
In my view, the decision as to when to start such a process of adjustment will likely come into sharper relief around the turn of this year.
Meanwhile, in the United States, Federal Reserve chairwoman Janet Yellen indicated that interest rates were likely to rise at the end of 2015.
As on previous occasions, talk of an interest rate rise in the UK was curtailed in the autumn. In November 2015 inflation remained low at 0.2%, which the BOE now expected to stay below 1% until the second half of 2016 (after the EU referendum), after which time inflation would likely rise back above 2% within two years. They also said that the outlook for global growth had weakened, further depressing the risk of inflation. Emerging markets were cited as showing weakness. A slowdown in China was also raised as having a possible impact on UK growth.
To summarise a clip of Mark Carney hosting the November Inflation Report press conference, it was here that he affirmed the objective of the MPC to,
return inflation to target in around two years and keep it there, in the absence of further shocks.
When bank rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles.
This was not without a customary caveat, however. Carney expressly went on to state that ‘this guidance is an expectation, not a promise‘, and that the ‘actual path of bank rate will depend on economic circumstances‘. Indeed, the November inflation report commented on how rates may now not rise until 2017 amidst global growth concerns and low inflation.
2015 closed out with the Federal Reserve raising interest rates for the first time since June 2006. UK GDP growth for the year came to 2.2%, a 0.9% drop on 2014. The unemployment rate was now at 5.3%, with earnings growth up to 2.5% (over 2% above inflation). In a BBC article detailing unemployment figures for December, they noted how Mark Carney had said on a previous occasion that he would like to see pay growth rise above 3% a year before considering a rise in rates. This is a further example of economic data falling marginally shy of what the BOE deemed acceptable to begin the process of gradually tightening policy. On numerous occasions we have seen how when it appeared the bank was signalling an imminent rise in rates, it later presented updated guidance on why it could not yet be done. Most importantly, the BOE had never once given an express promise that rates were heading up. Such talk was always predicated on evolving economic circumstances.
In part two we will begin by looking at the events leading up to the EU referendum and move on to how the fallout from the election laid the groundwork for the Bank of England to raise interest rates.