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One step at a time on interest rates, says Bank

With more people in work, pay increasing faster than inflation and a growing economy, now is the right time for interest rates to rise, confirms the Bank of England’s Deputy Agent for Greater London.

Lai Wah Co

September 2018

The UK economy recently took a symbolic step towards normality with interest rates rising to their highest level since 2009. After rates were cut following the vote to leave the EU, the first rate rise was in November last year – back to 0.5%.

When the Monetary Policy Committee (MPC) set interest rates earlier this summer, the economic data for the first part of the year looked weaker than expected. It wasn’t clear how much was due to bad weather and how much was underlying weakness.

So, the MPC waited until more data was available, which confirmed that the slowdown was a weather-related blip. Since then, the economy has performed broadly as expected.

More people are in work, pay is increasing faster than inflation and the economy is growing. It’s actually growing slightly faster than it can without generating inflation above the Bank’s 2% target.

That is the main reason why the committee decided now is the right time to increase rates a little to 0.75%.

But this level of interest rates is still providing substantial support to the economy. Think of the rate rise as a driver gently easing the foot off the accelerator as the car gets towards the top of a hill.

The Bank always sets interest rates to shepherd inflation towards its 2% target. But inflation is slippery and affected by many factors.

For example, sterling has fallen slightly in recent months, making it more expensive to import things from abroad. This is pushing inflation up.

Brexit negotiations and people’s reaction to decisions around Brexit will also have an important influence on interest rates for the next few years. There are far too many possible outcomes and reactions to define in advance exactly what would be right for the economy in different scenarios.

Assuming the economy continues to grow as expected and current assumptions about Brexit, as a very approximate rule of thumb we might expect one small rate rise each year for the next few years, or possibly slightly more.

However, changes to the economy mean that average interest rates in the UK are likely to be lower than they were pre-financial crisis for the foreseeable future:

  • People are living longer, so the economy needs more savings. That tends to push down interest rates. 
  • Productivity growth has also slowed since the financial crisis. With productivity growth weaker than it used to be, people can expect lower pay rises. 
  • And economic growth will be lower because the economy only grows through more people working or through workers becoming more productive.

Lai Wah Co is Deputy Agent for Greater London at the Bank of England.

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