Interest rates could rise sooner than you think

By MoneyWeek Editor John Stepek Mar 07, 2011

John Stepek

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Bank of England governor Mervyn King was on good form over the weekend.

In an interview with The Daily Telegraph's Charles Moore, he took the finance industry and the banks to task. Among other criticisms, he noted that the attitude has too often been that "if it's possible to make money out of gullible or unsuspecting customers, particularly institutional customers, that is perfectly acceptable".

It's a good read. I've always felt that Mr King's heart is in the right place. And I couldn't agree more with his assertion that "the concept of being too important to fail should have no place in a market economy".

But while I hope he gets his way with the banks, he has more pressing issues to deal with. Such as what to do about inflation and interest rates.

Mervyn King has a fight on his hands

Judging by his take on the banks at the weekend, Mervyn King must like a fight. And it's a good thing too. Because over the next few months, he's going to have a job convincing other members of the Monetary Policy Committee (MPC) that he's right on interest rates.

It's possible to defend Mr King's view that hiking rates would be "a futile gesture". From next month, we're all going to feel the pinch quite sharply. The point at which you start to pay income tax at 40% is being lowered. National Insurance contributions are going up. A swathe of benefits and tax credits are being altered. That won't be good for the consumer.

Soaring oil prices are a nightmare too. Petrol prices are hitting record levels. And Alan Duncan, the Overseas Development Minister, took the shine off our weekends by noting that if oil hits $200 a barrel then "£1.30 at the pump could look like a luxury". If petrol hits £2 a litre, a double-dip recession would be a foregone conclusion. So you can see why the idea of hiking rates seems risky to Mr King.

But not hiking rates might be risky too. And more and more members of the MPC seem to be coming round to that idea. As Andrew Sentance, the member most keen to raise rates has noted, the Bank does have some power to offset the impact of rising commodity prices. Higher rates would mean a stronger pound, which would reduce some of the pain.

Also, we've got the European Central Bank (ECB) threatening to raise rates now, even in the face of an unresolved debt crisis in Europe. That would put pressure on the UK, as Deborah Hyde notes on Citywire, because it would likely weaken sterling, and increase inflationary pressures further.

Obviously, European monetary policy is even more entangled in twisted political machinations than our own. More than anything else, Europe needs to keep the euro strong. As long as the continent is stuck in this debt crisis, any sign of a run on the euro could cause more panic in the periphery. By keeping the euro shored up, the ECB buys time for politicians to get some sort of lasting deal on the table. So I suspect that the threat of a rate hike is just bluff for now.

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What really matters for UK interest rates

What's more interesting – and what should probably be worrying the Bank more – is that even the Confederation of British Industry (CBI) is starting to push harder for higher interest rates in the UK.

More often you find business lobby groups calling for lower rates. After all, low rates traditionally mean more consumer spending and cheaper borrowing. But it seems that the CBI is more worried about inflation than rate rises. John Cridland, the CBI's director-general, said: "I don't think a modest increase in interest rates would destabilise an export-led recovery… We must not allow inflation to get back into the national psyche as a given".

This suggests to me that manufacturers – who are feeling the rebound in the economy most powerfully – are increasingly worried that their wage bills are going to be driven higher this year as staff expect life to keep getting more expensive. According to recent pay data, a significant proportion of the sector is seeing wage deals of 4%, well above the national average. It's this concern about rising wages, far more than oil prices or what the ECB decides to do, that will decide how rapidly rates are hiked in the UK.

There are no easy choices left

But whatever happens, it's unlikely to be pleasant for the UK economy. If rates go up, it could be painful. But if inflation gets any further out of control, it'll also be painful. The problem is that we've got too used to the idea that there's a 'magic' interest rate that will make everyone happy and keep the economy ticking along. That's not the case anymore. The best the MPC can hope for now is to make the 'least-bad' choice.

People hail ex-Federal Reserve chairman Paul Volcker as a hero now. But his cure for inflation in the early 1980s drove the US economy into a painful double-dip recession. And he wasn't very popular at the time. Our own central bankers are already getting a taste of that, and it'll only get worse for them.

As we've noted before, it all points to keeping your portfolio positioned defensively. And if you want some protection from inflation, then looking at the energy and food sectors is worth doing. If you're not already a subscriber, get your first three copies free here.

Oh, and I thoroughly recommend you read the interview with King in The Telegraph if you haven't done so already: Mervyn King interview: We prevented a Great Depression... but people have the right to be angry

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Comments (12)

Published in UK economy | More articles by John Stepek

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  • 1. JohnnyC

    (07 March 2011, 02:08PM)  Complain about this comment

    Plan A
    Raise intereste rates to 5% on the next Saturday before the MPC meets.
    Sterling will rise and the cost of imports will fall thereby reducing inflation.
    Fixed Rate borrowers will be very pleased and Investment Banks will be up in arms.
    Poor people will be very pleased, particulatly, those who cannot get a job as their benefits are shrinking on a daily basis due to inflation.
    George will be very pleased as he will not be pressured into raising social benefits that have been eroded by inflation and subsequently raising taxes and/or borrowing to pay for them.

  • 2. JohnnyC

    (07 March 2011, 02:40PM)  Complain about this comment

    Plan A (ctd.)
    Personally, I will be filled with confidence if the MPC do their job and get inflation under heir role and stop buying gold and spent money on Goods and Services produced in this country.
    I could go on and on here.
    The bottom line is this: as long as the MPC do nothing and give no clear indication o f what they are going to do and restore the faith that I had in them before October 2008 then I and many others in my middle-England world will continue to buy gold because we do not no what else to do. We trust the metal that cannot be destroyed!

  • 3. JohnnyC

    (07 March 2011, 03:03PM)  Complain about this comment

    Plan B.
    Leave interest rates as they are.
    I will continue to buy gold and other assets outside the US, EU, and UK and so will most other people who have money.
    The poor will continue to get poorer at the prevailing rate of inflation and the Investment Banks will continue to be the only entities to benfit.
    David and George will have to deal with social unrest or else raise social benefits and taxes and borrowing and we will all go down the toilet with bricks and mortar investments.

  • 4. EKTOPE

    (07 March 2011, 05:15PM)  Complain about this comment

    The word stagflation sounds familiar.

  • 5. Thuyein Kyaw-Zaw

    (07 March 2011, 06:02PM)  Complain about this comment

    What I think is the opposite of John Stepek. Interest rates will stay as they are now a lot longer than a lot of people expect. It's unthinkable to raise rates any time soon as the economic data are not consistently pointing to a solid recovery. Most recent services PMI slowed lower than expected. Andrew Sentence, a leading hawk in the MPC will be replaced soon and that would even lower the chance of rate rise.
    That means sterling is way overvalued and once the rate rise talks cool down, sterling may find its home permanently below $1.50.

  • 6. Roland

    (07 March 2011, 06:54PM)  Complain about this comment

    In my opinion I don't think we will see significant interest rate rises for some years unless commodity price inflation goes hyper or the prevailing political economics does an about turn. I don't think employees have much leverage for wage increases. I work in the knowledge economy (e.g. Google at one point) and my experience is one of general wage deflation. Meanwhile house prices are going sideways.

    We have already devalued 20% or so and now we are importing that as commodity price inflation.

    After the great moderation, the great rebalancing?
    Funny how the policy is low interest rates in both cycles.
    Gold looks solid to me.

    I am not sure the average Joe in the UK realizes how rapidly they are going backwards globally. Mervyn does, that's why he is embarrassed.

    The game changes if China collapses under Bernanke's inflation though.

  • 7. Roland

    (07 March 2011, 07:04PM)  Complain about this comment

    I am talking about wages in the West only of course. In Eastern Europe and Asia, wages are rising significantly.

  • 8. george

    (07 March 2011, 08:00PM)  Complain about this comment

    Everybody knows that interest rates 'should' be raised. Every single arrow is pointing that way and the longer rates are held down the faster and higher they will eventually have to go.

    However, we have politics playing it's hand here and the coalition is gambling that the timing will come good by the election, and the BOE is merely a puppet on a very slender piece of string. The fear of unemployment won't last much longer and the vast amount of workers are still working and they will want (and need) a pay rise very soon. This is where the BOE/government (same thing) plan will go so very wrong.

    A board of people with differing views come to a decision each month but then one speaks out of turn and guess what? They sack him! Great, just great....

  • 9. 888mate

    (07 March 2011, 10:49PM)  Complain about this comment

    The MPC fell for Brown, Blair, and Balls bring the wealth forward political strategy by keeping interest rates too low, and now they have no choice but to roll it back by keeping them low for the forseeable future. They will have more credability if they just admit it rather than misdirect with arguements that dont stack up e.g. They ignored imported deflation in their rate setting in the growth years but now exclude imported inflation from the same process. Apologise to savers and explain to borrowers that rates will rise only when they they have paid off enough of their mortgages to reduce the banking sectors bad debt exposure.

  • 10. TomGramps

    (08 March 2011, 01:26AM)  Complain about this comment

    You have it right 888, but I think the pressure will be too great and the rate will rise.

    What we don't want is to get into compitition with the rest of the world and see rise after rise after rise. Macro- economics is a fragile phenomenon, and with N. Africa and M. East issues, China, "EU issues" we have to caw canny.

    Politics is about making sure enough people like what you did (or you would have done) to ensure you are elected - so big mistakes are inevitable - maybe its time to re-think how it should all work!

  • 11. capitalbusiness

    (08 March 2011, 08:26AM)  Complain about this comment

    The uk economy is already on a knife edge and we now have higher oil prices and austerity cuts in the summer if the mpc put rates up too quickly by too much then we will double dip and loose our AAA rating and our debt repayments will increase like the greeks gov has

  • 12. JohnnyC

    (08 March 2011, 10:19AM)  Complain about this comment

    We shouldn't be worried about double-dipping. Why so obsessed with the economy retracting. It's a sign that individuals and companies are getting their houses in order and creating a solid platform for the future. I am very uncomfortable with this mountain of debt that has been the only reason we have seen GDP increase for the last 10 years.
    If the UK was an individual it's credit rating would be junk or speculative at best.
    We must cease following the herd, in this case the Central Banks that continue to print or keep rates low.
    I am delighted to hear that the CBI want higher rates - after all, it is their members and only their members that can lead us out of this artificial economy.

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