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UK interest rate cycle will be “longer and shallower”

UK interest rate cycle will be “longer and shallower”

Bank of England governor Mark Carney has warned that while interest rates will rise from the current level of 0.5 per cent in the next three years, the rate of increase will “proceed slowly” to a level in the medium term of roughly 2.25 per cent, half the historical average.

In a speech at Lincoln Cathedral the governor noted: “The need for Bank Rate to rise reflects the momentum in the economy and a gradual firming of underlying inflationary pressures – a firming that will become more apparent as the effects of past commodity price falls drop out of the annual inflation rate around the end of the year.”

He added, however, that the “timing and pace of prospective interest rate increases need to be put in perspective”.

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Mr Carney highlighted headwinds to growth and inflation including the appreciation of sterling by 7 per cent since the start of 2015 and the fact UK fiscal policy “is about to tighten significantly”. With the governor pointing out the IMF is predicting the UK to undergo the largest fiscal adjustment of any major advanced economy in the next five years.

“Taken together, these factors suggest that the ‘equilibrium’ real rate of interest, which was sharply negative during the crisis, will continue to be lower than on average in the past....Everything else equal, that suggests a prospective tightening cycle that, once it starts, will be longer and shallower than those of the past,” he explained.

In his speech he noted short term interest rates have averaged around 4.5 per cent since the Bank of England’s inception roughly 300 years ago, with an average pace of tightening of 50 basis points per quarter since the adoption of inflation targeting in 1992.

But he added: “It would not seem unreasonable to me to expect that once normalisation begins, interest rate increases would proceed slowly and rise to a level in the medium term that is perhaps about half as high as historical averages. In my view, the decision as to when to start such a process of adjustment will likely come into sharper relief around the turn of this year.”