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| Photo: AFP/SCMP |
On November 2, in a move that markets had largely predicted, the Bank of England’s Monetary Policy Committee voted 7-2 to raise its base rate from 0.25% to 0.5%. It was the first increase in a decade. Across the Atlantic, the Federal Reserve in America has increased rates four times since the financial crisis, and markets have assessed that there is a 98% chance it will do so for a fifth next month. Its interest rate currently stands between 1.00% and 1.25%.
Why has the Bank of England lagged behind the Federal Reserve in increasing the cost of borrowing? The primary reasons have been a stronger economic recovery in the US and uncertainty surrounding Brexit in the UK. The American labor market has performed strongly over the past few years, and corporate earnings have been at record highs. In the UK, on the other hand, Bank Governor Mark Carney cut rates as recently as 2016 in a reaction to the vote to leave the European Union.
What compelled the Bank of England to act now? Unemployment in the United Kingdom is at a 42-year low, and annual inflation exceeds the the Bank’s target of 2%. The Bank interpreted these as clear signs that the economy is reaching its full potential and thus that monetary policy no longer need be as dramatically expansionary.
The general effect of an interest rate increase is to raise the cost of borrowing and to make debt more costly to repay. Higher interest rates fundamentally reward saving over spending. This cools economies and helps keep inflation in check, as well as benefiting those, such as pensioners, who hold most of their assets in interest-bearing instruments. However, by discouraging borrowing, higher interest rates also reduce consumption and investment in the economy. This places a dampener on growth.
In its most recent biannual World Economic Outlook, the International Monetary Fund (IMF), an esteemed voice in economic policymaking, suggested caution on the part of central bankers. It opined that “monetary policy settings should remain accommodative”. The IMF cites “still-subdued” wages as indicative of slack in the economy that is not fully represented by cyclically low unemployment rates.
The Fund does note, however, that “stretched asset valuations and increasing leverage” do present serious challenges should interest rates remain low. The prevailing low interest environment of the past decade has encouraged a concerning increase in indebtedness among consumers and firms. This raises the spectre of a future “Minsky moment”—in which a small economic hiccup can cause the collapse of an ever more speculative column of investments, setting off a crisis of credit across the economy. That said, the IMF suggests “micro- and macroprudential supervision”—regulatory measures and tests of institutions’ ability to withstand credit shocks—as superior alternatives to the relatively blunt tool of interest rates increases.
Many analysts concur with this view, noting that higher inflation is largely a temporary consequence of the pound’s depreciation, which increases the pound price of imports, and will soon tail off without any action from the Bank of England. In addition, economic headwinds remain from the still incredibly uncertain outcome of Brexit negotiations. An unfavorable deal for Britain, or even no deal at all, could be seriously damaging to economic growth.
Commentators also observe that the British economy has a high degree of sensitivity to interest rates. Twice as many mortgages in Britain as in America are variable-rate instead of fixed-rate, meaning that an increase in interest rates makes it more difficult to make good on payments.
But perhaps, as high schoolers do with college admission decisions, some commentators are getting too worked up about the recent interest rate increase. After all, the Bank of England only raised rates by an unspectacular 25 basis points (0.25%), and has signalled that it intends to proceed with further rate hikes only gradually, if at all.
On the other side of the pond, the Federal Reserve appears likely to continue on its path of periodical interest rate hikes, as economic expansion gently chugs along. The President of the Boston Fed said in an interview with the New York Times that he would like to see the Federal funds rate at 2% percent by the end of 2018.
Underpinning the contractionary leanings of America’s monetary policymakers are economic stability and high levels of employment. Though inflation, currently at 1.3%, is still below he Fed’s 2% target, the Board of Governors maintains that it expects inflation to pick up in the medium term.
Further rate increases in the United States do run the risk of choking America’s delicate recovery, especially in a time of general political uncertainty and heightened geopolitical tensions. The Bank’s Governors do admit to being perplexed about the cause of consistently low inflation, which has led some to make the case for continued low rates for now.
Internationally, an increase in the Federal Funds Rate would see the US dollar appreciate, making dollar-denominated debts abroad more difficult to repay. This could imperil financial health in emerging markets. The Asian financial crisis of 1997, for example, was exacerbated by the spiralling costs of servicing US dollar debts as local currencies came under attack. These risks considered, emerging markets do hold far less dollar-denominated debts than they once did, somewhat minimising the risk associated with an appreciating US dollar.
Monetary policy is a delicate task. To make that little analogy of mine even more outrageous: just as college admissions officers have immense difficult differentiating between the legions of highly qualified applicants, so too do central bankers struggle to achieve consensus on which theories and data to assign greatest weight. And ultimately, despite the media hullaballoo, it is the fundamentals of the economy that drive interest rate changes more than tweaking the interest rates drives the economy.
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