Tony Dolphin: Strong case for interest rates staying at a low

IT is now over five and a half years since the Monetary Policy Committee (MPC) of the Bank of England cut its bank rate to 0.5 per cent. For the last five months, two members of the MPC have been voting to increase the rate to 0.75 per cent, while the other seven members have opted for the status quo.

However, interest rates are not expected to remain at rock bottom levels throughout 2015. In HM Treasury’s December comparison of economic forecasts for the UK economy, only two out of 32 forecasters reporting a view on interest rates at the end of 2015 said they thought rates would still be 0.5 per cent.

It is to be hoped that all these forecasters are proved wrong, because interest rates in the UK should not be increased in 2015.

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The main argument for higher interest rates is the strength of economic growth and the associated fall in unemployment. The latest figures, for the third quarter of 2014, show annual real GDP growth of three per cent. Most forecasters expect growth to ease in 2015, reflecting weaker growth in the global economy – what David Cameron has identified as “red lights”.

However, this weaker global growth has brought with it the considerable dividend of lower oil prices. These have already caused a big drop in petrol prices and energy companies are under pressure to cut gas and electricity prices.

If the energy companies respond to this pressure, households in the UK are likely to see their living standards improve by more in 2015 than in any year since the financial collapse. The tightening of the labour market should be accompanied by a modest increase in wage inflation and consumer price inflation will drop below one per cent. This is very likely to generate stronger growth in consumer spending. UK companies would also benefit from lower energy costs, allowing them to continue to boost investment spending, as they have been doing in 2014.

There is no reason to believe, however, that another year of growth of even three per cent would lead to a marked increase in domestic inflation pressures.

In particular, wage inflation is likely to remain well below the level believed to be consistent with the inflation target.

For a brief period, Mark Carney – the Governor of the Bank of England – linked consideration of interest rate increases in the UK to the level of unemployment, suggesting that rates were more likely to go up when unemployment fell below seven per cent. With hindsight, this was a mistake. Unemployment is now six per cent but interest rates have not increased because low unemployment has not been accompanied by evidence of wage pressures.

The labour market in the UK is now too complex to be judged by the rate of unemployment alone. Rapid employment growth, steep falls in unemployment and an employment rate back to the level seen before the financial collapse all give a potentially misleading picture. Involuntary part-time and temporary working are at high levels and many people are self-employed when they would rather be working as an employee. This “hidden unemployment” means the UK is still some way from full employment. Only when overall employment growth is accompanied by falls – or at least slower growth – in part-time and temporary working and in self-employment will the labour market be signalling the need for higher interest rates.

A more important consideration is the need for the MPC to take account of likely developments in fiscal policy. It is a moot point whether monetary policy or fiscal policy should be tightened first – should we have higher interest rates or deficit reduction? But there is nothing in the economic outlook to suggest that both need to be tightened simultaneously.

We will not know the exact path that fiscal policy will take in 2015 and 2016 until after the general election, but at this point it seems likely that it will not deviate greatly from the path set out by George Osborne in his Autumn Statement. This implies a significant tightening of fiscal policy, and the MPC needs to take account of this when thinking about interest rates.

Of course, no one can predict with any certainty what will happen over the next 12 months and the reason the MPC meets monthly (though Mark Carney believes this could be reduced to eight times a year) is to allow it to continually reassess interest rates. It might be that economic growth in 2015 is even stronger than it has been in 2014 and that worrying signs of inflation pressure start to appear. If so, higher interest rates would become probable.

But low wage and price inflation appear to be the more likely outcome and when they are combined with the likelihood of a significant tightening of fiscal policy over the next two years, the case for keeping interest rates at their current level starts to look compelling.

Tony Dolphin is the chief economist at the Institute for Public Policy Research.