A delicate rate balancing act for the BoE

Solid economic growth and a heated property market mean the Bank of England is under mounting pressure to raise interest rates. But several factors are complicating matters.

The Bank of England left rates and its stimulus program unchanged at its July meeting, but that doesn’t mean that it doesn’t have a lot to think about over the next six months. The UK is growing at a solid pace and with the labour market improving more rapidly than expected, there is mounting pressure on the BoE to raise rates sooner rather than later.

The UK’s cash rate will remain at 0.5 per cent – as it has since March 2009 – while the BoE also voted to maintain its stock of asset purchases at £375 billion. Neither decision came as a shock, but bank officials have hinted in recent weeks that a rate rise could occur earlier than the market anticipates.

The minutes from the last two meetings – not including the meeting overnight – also indicate that some members of the committee are beginning to shift their views as well.

The UK economy rose by 0.8 per cent in the March quarter – outpacing Europe and most of the developed world – and is set to rise at a solid pace throughout the remainder of the year. According to the Institute of Economic and Social Research, the UK economy expanded by 0.9 per cent during the second quarter.

BoE governor Mark Carney has indicated that rates could normalise to around 2.5 per cent by 2017. This indicates a slow and steady approach to monetary policy but also highlights the risks facing the UK economy. If 2.5 per cent is the ‘new normal’ then the BoE won’t have much room to move or ammunition when faced with another downturn.

But while a rate rise by the end of the year seems inevitable, it isn’t all smooth sailing. Some recent data even suggests that the BoE can take its time before raising rates.

Inflation eased in May, to be 1.5 per cent higher over the year. The core measure – which excludes volatile items such as food and energy – slowed to 1.6 per cent over the year to May. Both measures are below the BoE’s upper target for annual inflation of 2 per cent.

Although the labour market has firmed over the past year, the same cannot be said of wage growth, which has continued to ease in recent months. As a result, there is clearly more spare capacity within the economy than is indicated by the unemployment rate.

The British pound also continues to be strong, approaching a near-six year high against the US dollar. This is likely to weigh on export growth but also inflation, reducing the urgency for a rate rise.

The BoE has also taken steps to reduce that urgency by introducing measures to slow household lending. Under new guidelines, mortgage lenders will be required to ensure that no more than 15 per cent of their new home loans have a loan-to-income ratio of more than 4.5 times.

The measures are designed to cool an increasingly overheated housing market. According to mortgage lender Nationwide, house prices have increased by 25 per cent in London over the past year.

The UK’s housing policy is an absolute mess -- sharing a number of similarities with Australia’s system -- but it is hoped that restrictions on lending will allow the BoE to ignore housing when it considers its next rate move. There was a very large risk that housing would take monetary policy hostage, resulting in rates rising faster than is ideal for the remainder of the economy.

The UK economy is set to go from strength-to-strength over the second half of 2014 and is well placed for next year as well. Despite inflation easing a little, the BoE will likely raise rates by the end of this year but ideally it will take a slow and steady approach to monetary policy.

Households remain highly indebted but hopefully new macroprudential rules will encourage improved lending standards and an easing in house price growth. If that doesn’t occur then high levels of debt will continue to weigh on spending and force the BoE to react by raising rates more quickly than they’d prefer.