UK interest rate rise now tipped for August 2015

5th June 2014

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The Bank of England may raise interest rates earlier than expected says Schroders’ European Economist Azad Zangana.

In a note about the UK economy and rate prospects Zangana says: “Stronger growth raises the prospects that the Bank of England (BoE) may raise its policy interest rate sooner than expected. While inflation in the near term remains benign, the Bank is considering the profile of future interest rates.

“The debate seems to be heading towards the notion that an earlier start to the hiking cycle will allow the BoE to ease the squeeze on the household sector by hiking more slowly. Macroeconomic theory points to the importance of the level of interest rates for long-term economic growth, but in the short-term, the change in interest rates is more important. Therefore, the BoE should take as much time as possible in normalising rates.”

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Zangana says that recent speeches by Monetary Policy Committee member Martin Weale may show shifting sentiment.

Zangana continues: “This debate has been highlighted by recent interviews by Martin Weale, an external member of the BoE’s monetary policy committee. As the Bank forecasts the output-gap to be closed by around mid-2017, in theory, it should want to ‘normalise’ interest rates by then.

“The first question that arises is what the new equilibrium rate actually is. In the past, 4-4.5% seemed to be the preferred neutral rate, but the Bank has strongly signalled that this is now too high post the financial crisis. Not only is trend GDP growth expected to be lower, but there is an argument that prior to the crisis, banks were not charging enough of a premium (spread) over the Bank’s risk free rate – implying that lending risks were being underestimated. If lenders are now charging more appropriate premiums, then the Bank of England can achieve the same effective interest rate (true average interest rate charged to households and corporates), but now with a lower base rate.

“In our view, the Bank is likely to remain very cautious and will look to raise interest rates by no more than 25 basis points each quarter. Even Martin Weale – a more hawkish member – agrees with this pace of tightening. He may start to call for rate increases in the near future, but we forecast the BoE to remain on hold until August 2015. This is sooner than previously forecast (start of 2016), but is later than is priced in by money markets. The market is pricing in a strong chance of the first rate rise by February 2015, and at least the first rise by May 2015. As the next general election will be taking place at that time, in our view, it would be strange for the BoE to introduce additional market uncertainty by raising interest rates. We think August 2015 is therefore more likely.”

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