Interest rates and inflation: Key issues for the 2015 Parliament
Following the worst financial crisis in a century and the longest downturn on record, the Bank of England cut its official interest rate (known as the Bank Rate) to 0.5% in March 2009, the lowest level in its 320-year history.
The rate has remained unchanged ever since. None of the nine members of the Bank's interest rate-setting body, the Monetary Policy Committee (MPC), was on the MPC the last time interest rates were changed.
It is broadly accepted that the Bank Rate will eventually rise: this in turn will influence interest rates throughout the economy, including rates on new and variable-rate mortgages.
Chart 1: Bank Rate and average interest rates
Where Bank Rate goes... changes to the 'official' Bank Rate influence interest rates throughout the economy.
Bank Rate and average (effective) interest rates on selected new bank lending, January 2004 to April 2015
But after such a prolonged period without change, the consequences of this “unwinding” of loose monetary policy are unpredictable. Equally, should the economic situation worsen and low inflation persist, there is far less scope than there was before the financial crisis to reduce the Bank rate in response.
In deciding when to raise rates, the MPC will be guided by its remit, provided by the Chancellor, which currently specifies that the Committee should target an inflation rate of 2%, as measured by the Consumer Prices Index.
In judging the extent of inflationary pressure, the MPC gives much consideration to the amount of spare capacity in the economy: that is, the difference between the existing size of the economy and its potential size.
The more spare capacity, the more scope there is for the economy to grow, without putting pressure on prices. However, estimating the level of spare capacity, and how fast it is being used up over time, is extremely difficult, making the exact timing of a rate rise uncertain.
Market expectations at the start of May 2015 were that the Bank Rate would not rise until July 2016.
In addition to ensuring price stability, the Bank of England also has an objective to protect and enhance financial stability. System-wide risks to the financial system are monitored and dealt with by the Bank's Financial Policy Committee.
In normal times, the Bank's two objectives of price stability and financial stability are broadly complementary. However, a prolonged period of low interest rates has driven down the return on many investments, and prompted some investors to turn to riskier assets, in a “search for yield”.
Financial markets may have become very sensitive to signs of a rise in interest rates. As such, the “normalisation” of monetary policy will have to be managed carefully if it is not to cause volatility; and there may be a tension between price and financial stability if inflationary pressures mean interest rates have to rise more quickly than markets expect.
Households too have grown accustomed to very low interest rates. Those with high levels of debt relative to their incomes, particularly mortgage debt linked to the Bank Rate, could face difficulty keeping up with repayments were interest rates to rise sharply.
This in turn could have a damaging impact on banking stability. Total household debt was just under one and a half times household disposable income in 2014 (the vast majority being mortgage-related debt): this ratio has fallen in recent years from its pre-recession peak, but remains well above the level seen in the late 1990s.
The Office for Budget Responsibility forecasts an increase in the debt-to-income ratio over the coming Parliament.
Chart 2: Household debt-to-income ratio
The household debt-to-income ratio is expected to rise above its pre-crisis peak by 2020. Household debt as a percentage of annual disposable income, Q1-1997 to Q4-2014 and OBR forecasts to Q1-2020
To mitigate the risks, in June 2014, the Financial Policy Committee recommended that limits be placed on the proportion of mortgage lending that can take place at loan-to-income ratios above 4.5.
It also recommended that mortgage lenders be required to assess whether borrowers could still afford their repayments were Bank Rate to rise by 3 percentage points at any point during the first five years of the loan.
Slow and steady?
The economic impact of a rising Bank Rate depends in large part on how far and how fast it is increased, and the extent to which these increases deviate from what is expected.
In order to clarify its intentions and thinking, the MPC has provided “guidance” that, when the Bank Rate does rise, it will do so gradually, and even once the economy is “back to normal”, the rate is likely to be “materially below the 5% level set on average by the Committee prior to the financial crisis”.
These commitments are conditional on the state of the economy, however: unexpected economic news could lead to equally unexpected interest rate changes.
A rise in interest rates will also have distributional effects. An increase in interest rates means higher costs for borrowers but also higher income for savers.
According to a survey by the Bank of England, higher interest rates distribute income away from younger households towards older households, and away from households with higher incomes towards those with lower incomes. Changes in interest rates will also affect the economy as a whole.
The same Bank of England survey found that borrowers cut their consumption in response to a rate rise by more than savers increase consumption, so demand in the economy as a whole falls.