The economy is humming along. Growth will be strong this year and next. Wages have started to rise more rapidly than prices. Interest rates have been at 0.5% for more than five years. So when is the first increase in borrowing costs coming?
Not yet. That was the clear message from the governor of the Bank of England, Mark Carney, as he opened his Inflation Report press conference with a nod to Karl Marx. “A spectre is now haunting Europe,” the governor said. “The spectre of economic stagnation.”
The Bank thinks the weakness of the eurozone will affect growth in the UK, but not by much. Exports will take a bit of a hit and investment is expected to soften slightly, but the outlook is still rosy.
A number of factors explain the Bank’s optimism. It thinks 2015 will be the long-awaited year of the pay rise, something that was heralded by the latest labour market statistics from the Office for National Statistics on Wednesday showing that regular pay excluding bonuses was 1.3% higher in the three months to September than in the same quarter in 2013. Using the CPI measure of the cost of living, inflation stood at 1.2%.
In addition, Threadneedle Street thinks consumer confidence is robust and that the knowledge that rate rises are likely to be gradual and limited is encouraging investment. Market interest rates have come down in the past three months, and the benefits are being passed on in the form of lower mortgage rates.
But while the Bank has only slightly pared back its growth forecasts since its last Inflation Report in August, the same can’t be said of inflation.
Threadneedle Street did not expect inflation to come down with such a bump and expects a further moderation in the months to come. CPI inflation is forecast to be 1% in the first half of next year, with a better-than-even chance that it will slip below 1% for the first time since 2002.
That would require Carney to write a letter to the chancellor explaining why inflation was more than a percentage point away from its 2% target and what – if anything – the Bank’s monetary policy committee intended to do about it. The chances of Carney raising rates at the same time as he is writing letters explaining away low inflation look pretty slim. That’s why George Osborne can assume that there will be no rate rise this side of the election.
This is not a cast-iron guarantee. Wage growth could be a lot stronger than the Bank is expecting and be unaccompanied by even the modest improvement in productivity that the MPC is predicting. The sharp drop in commodity prices that explains most of the recent fall in inflation could be reversed. The eurozone could rise Lazarus-like from the dead. In those circumstances, the City would bring forward the date at which it expects rates to start rising.
There is a precedent for the Bank not allowing big movements in commodity prices to affect its decisions on interest rates. When inflation hit 5% in 2011, the Bank assumed the impact of dearer oil and food would be temporary, and that raising interest rates would lead to an unnecessary loss of output and jobs.
But Carney made it clear the Bank was less minded to “look through” recent developments in commodity markets. Threadneedle Street is assuming that the forces driving down inflation will persist for some time, and that they are being amplified by weak domestic inflationary pressures. Despite an increase in employment of almost 700,000 over the past year, the Bank still believes there is slack in the labour market that will prevent a wage-price spiral from taking off.
That assessment could change. But it would have to change fast to trigger a rate rise before polling day.
