OpinionOct 9 2014

Higher interest rates on the way

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The old joke goes that economists have three hands and never give a straight answer, much to the frustration of US President Harry Truman, who demanded: “Give me a one-handed economist!”

I am not an economist, and luckily I have two hands. In those hands I am currently weighing up the implications for the path of interest rates of new figures from the Office of National Statistics showing that the UK economy has actually rebounded from the recession faster than had first been thought likely. Little change, is my conclusion: higher rates from the Bank of England are coming, but when they do, they will rise gradually.

Statistical agencies around the world are aligning the way they measure the size of national economies to reflect new areas of economic growth, such as intellectual property, as well as the more shadowy ones. Earlier in the year, Nigeria increased the size of its economy by nearly 90 per cent overnight through a bit of data massaging and rocketed past the old number one African economy, South Africa. Meanwhile, the US recently completed an overhaul of previous GDP numbers, and Spain and Italy have also made similar adjustments.

Based on the new ONS figures, the UK economy is around £50bn bigger than under the old methodology. What is more, it is now 2.7 per cent larger than before the global financial crisis started in 2008, compared to only just nudging above the previous peak. But while there were some surprises in the revised data, most of the good news had already been factored in and will do little to change the BoE’s view on recent momentum in growth.

BoE governor Mark Carney recently repeated an earlier message stating that: “The point at which interest rates also begin to normalise is getting closer.” In other words, get ready for higher rates. This is despite the facts that wage growth is non-existent – and negative in real terms – and that inflation is predicted to remain below the BoE’s 2 per cent target over the medium term.

The central bank will be reassured by the softness in the housing market given past concerns about the potential for a bubble. The latest figures from Nationwide showed that house prices fell for the first time in September on the previous month. Meanwhile, mortgage approvals fell in August for the second month. Some may argue that the cooling of the housing market is a reaction to the macro-prudential rules set by the BoE and the Financial Policy Committee.

The central bank will be reassured by the softness in the housing market given past concerns about the potential for a bubble

The FPC wanted to restrict high loan-to-income mortgages based on concerns over how households would cope as mortgage rates rose, impacting on the UK consumer, which has been driving the economic recovery thus far. But the restrictions, set at such a level as they are, do not yet bind lending by banks as they are above the thresholds most banks may already be using, and are largely precautionary, so are unlikely to fully explain the cooling in the housing market. It is more likely that buyers have started to baulk at some of the asking prices for many homes (especially in London and the southeast of the country), causing appetite to wane slightly.

So in this consumer-driven economy, what will higher rates mean for households? Those who wanted to lock in low fixed-term rates for their mortgages should have done so a while ago. Fixed rates have risen as markets price in the expectation of higher rates in the future, but floating rates for mortgages have actually been falling. This may be an indication of high street banks trying to steal more market share at a time when the housing market has been improving. If this is the case, then a more competitive mortgage market suggests that as the BoE begins to normalise rates, the impact on mortgages may be less adverse than had been thought. It may also allay some worries over the resilience of the all-important UK consumer.

The timing of interest rate rises is hotly debated, with much of the decision still data-dependent. So what would a three-handed economist say? On one hand, the economy has recovered faster than first thought, but on the other, wage growth remains weak and inflation is contained – and on the other hand, the unemployment rate is falling quickly, and there is likely less slack in the economy than the BoE thinks. Three hands aside, the bottom line is this: higher rates are coming, but the pace of increase will be measured, so any negative economic impact should be limited.

Kerry Craig is global market strategist of JP Morgan Asset Management