Economic update: Interest rates raised as growth recovers

Last week the Bank of England’s Monetary Policy Committee (MPC) voted unanimously to raise interest rates to 0.75% from 0.5%. This is the highest they have been in almost a decade, although they are still very low by historical standards.

Interest rates rose for the second time in a year

The decision to raise interest rates in November 2017 was the first since the summer of 2007. Now, in the space of a year the MPC has voted to increase rates on two occasions. As the chart below shows, however, they remain well below the levels seen at the time of the 2007-2009 financial crisis.

Official UK interest rates

Inflation remains above the 2% target

The Government has set the MPC a 2% inflation target, and the MPC will adjust interest rates with the primary intention of meeting this target.

In June 2018, the Consumer Price Index (CPI) inflation rate was 2.4%, unchanged from May but below levels seen for much of 2017 and the start of 2018, when it was around 3.0%. These higher rates of inflation were partly a result of a rise in import prices due to sterling’s fall following the EU referendum. The last time inflation was either equal to or less than the 2% inflation target was in January 2017.

UK Consumer Price Index

The MPC stated that most of the rise in import prices has now been passed on to consumer prices, and therefore have forecast that the inflation rate will begin to gradually decline towards the 2% target, reaching it around the end of 2020.

The economic dip in Q1 2018 appears to be temporary

Following the March meeting of the MPC, the expectation was that its members would vote to raise interest rates at the next meeting in May. However, at this meeting, the MPC voted to keep interest rates unchanged at 0.5%, with a key reason being the economic slowdown in the first quarter of this year. Provisional estimates of GDP had showed growth of only 0.1% in this quarter, which was the slowest growth since 2012. The estimate for this quarter has since been revised to 0.2%.

A key question since then has been whether this subdued growth was a temporary dip, at least partly caused by the adverse weather in this quarter, or whether it would prove to be part of a more sustained slowdown.

The economic data published since the May meeting has been mixed but sufficiently strong enough for the MPC to conclude the first quarter slowdown was temporary, and that momentum has recovered somewhat in the second quarter.

The MPC has reported that it expects growth to be 0.4% in Q2 2018. The ONS will publish a first estimate for this quarter on Friday August 10.

Unemployment continues to fall, and pay growth is expected

The number of people who are unemployed fell by 12,000 in the three months to May 2018, with a fall of over a million people over the last five years. In this period, the unemployment rate was at its joint lowest rate since 1975, and it is projected to fall further in the second half of 2018.

A consequence of the low levels of unemployment is an expectation that there will be an acceleration in wage growth over coming years. The MPC has stated that this could lead to inflationary pressures.

Further increases in the interest rate are likely to be “at a gradual pace and to a limited extent”

Despite interest rates being raised on two occasions in the last year, they remain at a very low level, and the MPC has stated that future increases “are likely to be at a gradual pace and to a limited extent”.

As a result it seems unlikely that rates will quickly rise back to the levels seen prior to the financial crisis. Governor of the Bank of England, Mark Carney, has stated that a good rule of thumb for future interest rate rises is a one quarter point rise per year for the next three years.