It’s been a long time since a full parliament elapsed without an increase in interest rates. The last time it happened was between 1945 and 1950 when Clement Attlee’s Labour government held the official cost of borrowing at 2%.
It looks increasingly likely that David Cameron’s administration will be the next. Despite being on course to be the fastest growing economy in the G7 group of industrialised nations this year, the chances of the Bank of England raising borrowing costs before the next election are receding.
Interest rate sentiment in the City has changed markedly in the last couple of months. When two of the members of Threadneedle Street’s monetary policy committee – Ian McCafferty and Martin Weale – said in August that it was time for a rate rise, the assumption was that it was only a matter of time before the other seven agreed. November 2014 and February 2015 were seen as the likeliest dates for a move. Now the date being pencilled in to diaries is August 2015.
So what’s happened? One factor has been the marked deterioration in the outlook for the eurozone, comfortably the UK’s biggest trading partner. A second has been the market turmoil of the past couple of weeks, which in part has been caused by fears that Europe is well on the way to becoming the new Japan.
There is, however, a bit more to the story than that. As the Bank’s chief economist, Andy Haldane, noted last week, the economy seems to be doing remarkably well and remarkably badly at the same time. Haldane’s ecstasy index – an amalgam of growth, unemployment and inflation – has only been higher than current levels in five of the past 44 years.
On the other hand, his agony index – a mix of real wage growth, productivity and real interest rates – shows that Britain has only been enduring the current levels of extended pain three times in the past one hundred years: in the aftermath of the two world wars and in the 1970s.
The task for the Bank when setting interest rates is to assess the strength of these two different trends. Throughout the recovery, the Bank has assumed that at some point stronger growth and falling unemployment will be accompanied by higher wages and a rebound in productivity. But time and again, reality has failed to live up to expectations.
That’s because the Bank’s model of the economy doesn’t truly reflect what’s been happening. Put simply, the MPC has underestimated the slack in the labour market and this has influenced its thinking about when rates might need to start rising in order to hit the government’s 2% inflation target. For the past year, the Bank has been waiting for wage inflation to take off.
It hasn’t happened. Three-quarters of a million net new jobs have been created in the past year but average earnings are growing by less than 1% a year. As a result, the Bank has decided that there is more slack in the labour market than it thought and that its model therefore needs some recalibration. This rethink was going on even before concerns were raised about the eurozone and would have influenced the Bank’s next quarterly inflation report, due out next month, even if the financial markets has not tanked in recent weeks.
Haldane explored some of the reasons why the labour market has changed in a speech he made in Kenilworth last week. There has, he says, been strong demand for high-skilled labour and for low-skilled labour, whilst the mid-skill segment of the workforce has been hollowed out.
Recruitment surveys suggest employers are prepared to offer above-inflation salaries to those at the top but they feel no need to be so generous to those at the bottom. In part, that’s because those mid-skilled workers who lose their jobs look for work for which they are over-qualified. In part it is because older people, fearful about the state of their pensions, are working longer. In part, it is also because the workforce is increasing, both as a result of demographics and as a result of immigration.
The big increase in employment over the past year shows that work is being found for this increased pool of labour. But quite often it is part-time work stacking shelves in a supermarket or the former full-time plumber, now self-employed, finding a few washers to replace. Most of the rise in employment is coming in low-productivity jobs, which is why output per hour worked in the UK in 2013 was 17% below the average for the G7 – the widest gap since 1992. Ultimately, the level of real wages is linked to productivity, so low productivity equals low wage growth, equals low inflation, equals low interest rates.
Stir in two other factors and it is even easier to see why forecasts of the date for the first interest-rate rise keep getting pushed back. The first is that the economy has slowed a bit and is likely to slow further over the winter. Real incomes are falling, the sugar rush from the housing market has worn off (in part because the Bank has reined it in) and the global outlook has darkened. The Bank was expecting the pace of recovery to slacken in the second half of 2014. If anything, the slowdown will be a bit more pronounced.
The second factor is the likelihood that the stance the Bank of England takes here will be influenced by the stance taken by other central banks. What is happening, according to Stephen King, the chief economist at HSBC, is a monetary policy tug of war with the Bank and the US Federal Reserve pulling in one direction and the European Central Bank and the Bank of Japan pulling in the other. In the UK and the US there is pressure for policy to be tightened; in the eurozone and Japan there is pressure for it be loosened.
The assumption is that the ECB and the BoJ will try to drive down the value of the euro and the yen and hence make their exports cheaper through the process known as quantitative easing, the creation of electronic money to purchase bonds. When official interest rates and the interest rates on government bonds are at rock-bottom levels – as they are currently – this is pretty much the only way QE can lead to stronger growth.
But as King noted, this is really just a modern version of the beggar-my-neighbour tariff wars of the 1930s. A falling exchange for the euro and the yen has to mean a stronger exchange rate for somebody else, and a stronger exchange rate means imports become cheaper and inflation goes down. How will the Fed and the Bank react to this attempt on the part of the ECB and the BoJ to export their deflation to somebody else? Easy. By delaying rate rises.
