Shadow MPC: New year, same old rates

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Despite a solid mortgage market, UK interest rates are unlikely to follow those in the US any time soon

The new year has resurrected familiar worries for UK investors, with data from China coming in below expectation and hints from the US that its economy may lack the strength to carry the rest of the world in the slipstream of its growth.

Those that have been advocating an interest rate rise in the UK generally deploy one of two arguments. The first is that the exceptionally low rate of inflation is the consequence of very short-term factors, such as oil and commodity prices being in the doldrums. Indeed, the UK annual inflation rate is likely to move upwards this year as the impact of the collapse in the oil price falls out of the data.

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The opinion here is that the current low unemployment rate will result in wages rising and that, combined with more robust oil and commodity prices, it will lead to a rapid acceleration in the inflation rate, creating a real threat to the UK economy.

The second argument is that, contrary to expectations and theory, the present low interest rate and the quantitative easing policies of central banks have actually contributed to deflation in the global economy, rather than the inflation that was anticipated.

Meanwhile, the counter-arguments centre on the present level of unemployment not being a reliable indicator, because of both the quality of the jobs being created and the fact that changing demographics in the Western world mean the proportion of the working-age population is shrinking. The opinion here is that unemployment should fall naturally because there are fewer workers chasing each job.

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Some economists believe the QE and low interest rate policies being pursued in the eurozone and Japan effectively export deflation to the rest of the world and keep commodity prices low, meaning there is little chance of the sort of inflation shock feared by others.

Advocates of rates staying low or even being cut further, including star fund manager Neil Woodford, take the view that the deflationary conditions in the global economy are only partly the consequence of short-term factors such as commodity and oilprices. They assert that deflation may be a longer-term trend, as it was in Japan in the 1980s, leading to stagnant economic growth.

The Bank of England traditionally follows the Federal Reserve when it comes to raising rates, with increases here happening around six to nine months after the US. London Capital Group head of analysis Brenda Kelly recently said the UK’s economic outlook did not look robust enough for rates to be raised any earlier than this traditional lag and any rush to do so beyond that might be stilled by the uncertainty of the looming EU referendum. This would potentially push the rise further into 2017, if at all.

When the US raised rates in December, global markets gave a collective sigh of relief, taking it as a sign the global economy was stabilising. However, the poor performance of markets since and the weak data from China and the US show the potential consequences if the BoE gets its timing wrong.

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Whatever the causes of the recent weakness, inflation is unlikely to recover back to target without a marked improvement in wage growth, according to the Monetary Policy Committee’s Martin Weale. More people than ever are working part-time, translating to a fall in the average number of hours worked per week. Weale believes unit wage costs are the most important indicator of domestic costs: sustained growth at more than 2 per cent a year is not consistent with the inflation target unless other costs (of raw materials and imports, for example) are growing more slowly than this, as they are currently.

This is particularly true given the recent backdrop of further falls in the oil price driving petrol and energy-related costs down.

The general tightening in the labour market, as indicated by the continued fall in the unemployment rate, means we may see some acceleration in wage growth in the second half of this year. Other members of the nine-strong MPC have said wage growth is not high enough to justify a rate rise.

Given that the International Monetary Fund has lowered UK and global GDP forecasts for this year, and there is still some debate about the Chinese and US economies’ impact on global trade, consumption and inflation,

I believe interest rates will remain at 0.5 per cent this month despite a solid UK mortgage market.

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Mehrdad Yousefi is a banking consultant