Web feature: Will the Bank of England raise the base rate in 2014?

Written by Sarah Willis
02/06/2014

The first thing Mark Carney did when he took over as Governor of the Bank of England was announce he would consider raising the base rate from its historic low of 0.5 per cent only once unemployment had fallen to 7 per cent.

At the time that threshold seemed distant, and this piece of forward guidance was designed to calm investors worried about a rate rise happening sooner rather than later. With unemployment falling faster than expected – will Carney keep to his word?

Let's take a look at what the BoE has to take into consideration.

Private debt

The rationale behind instituting such a low base rate was to make borrowing cheaper, and saving expensive – encouraging spending and making cash available to do so.

The flip-side is that once rates go up, everyone who took out a cheap loan/credit card/mortgage suddenly has to pay much more just to service their debts, let alone pay them off. The knock-on effect is less money going into the economy.

Get the timing wrong, and a modest recovery could easily be choked off.

The biggest worry is mortgages. Research by the Bank of England itself found that should interest rates be lifted to a more normal 3 per cent, “it would almost double the proportion of... “vulnerable mortgagors” – those forced to spend at least 35 per cent of their pre-tax income on repayments – to 16 per cent”.

An increase in earnings alongside rates would absorb the extra cost of repayments. This could happen - a recent CBI survey found 42 per cent of responding firms believed salaries would rise in line with RPI measured inflation in 2014. But that's still a minority, and still only an arguably optimistic belief in the context of long-term wage stagnation.

The housing market

On a related note, a rate rise would make getting a mortgage in the first place more expensive. First-time buyers already struggle getting a deposit together – which is why the Help to Buy scheme was introduced. But even with government assistance, a higher ongoing repayment cost could well put off would-be homeowners whose incomes are already squeezed.

Meanwhile, an upswing in property sales has historically been the biggest stimulus of recovery. People always need houses. And the more houses are bought, the more money there is to build houses. The more houses are built, the more money construction firms are paid. The more construction firms are paid, the more supplies are bought. And so on. The property supply chain is vast. A healthy property market lifts the wider economy probably more than anything else.

The construction sector is currently optimistic, buoyed by a raft of commercial building projects. But an ill-timed rate rise could well spell an end to nascent construction growth.

Equally, the BoE is on record as being concerned about a potential housing bubble, and cancelled the Funding for Lending Scheme designed to provide cheap mortgages in order to counter this. Preventing such a bubble is actually a possible reason for a rate rise.

Currency

Sterling is generally a strong currency. This makes imports cheap, exports expensive. Exports stimulate the economy. Imports do not. So the cheaper sterling remains, the better it is for the economy.

If, as predicted, the UK is one of the first to break ranks and increase the base rate, sterling will become stronger – made more valuable by the interest income, particularly for Forex traders dealing in carry-trades (profiting on the difference between interest rates in a currency pair).

The stronger sterling is, the more expensive buying from the UK is. And while our manufacturing sector is celebrating a rare piece of good news – highest projected growth for 2014 in the EU – the last thing it needs is a downturn in export demand.

Savings and pensions

So far it would be tempting to just leave the base rate where it is. But this would be unsustainable. The flip-side to everything we've considered so far is that low interest rates mean savings and pension pots depreciating in value, certainly in the kind of high inflation environment we've experienced in the last few years.

Inflation has finally fallen to the BoE's target of 2 per cent, so there are now some savings products – mostly bonds and ISAs – that beat inflation, but not by much.

The chief danger here is that as pension funds have to stretch ever further, making it even more difficult to build large enough pots is like lighting a decades long fuse on a pension bomb. According to pension provider Fidelity's calculator, we need a £633,000 pension pot for even a modest retirement income. That's already difficult enough to accumulate without interest rates being far below the standard 5 per cent growth the calculator assumes.

Timing the rise

Clearly the rate needs to rise. But doing so will inevitably have a negative impact on the economy in the short-term. The trick is timing it at a point when the economy is robust enough to absorb the hit.

Will that be 2014? Unlikely. Noises from the Bank are already emphasising Carney's promise was to “consider” raising the rate once unemployed fell below 7 per cent, rather than stating he would raise the rate. This is probably wise. Considering the slew of positive economic news hitting the headlines in recent weeks, it would be easy to get carried away. But growth is still modest and relatively new. Raising too early could easily set us back.

Next year on the other hand...

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