UK interest rates have been unchanged for five years. There has not been such a long period of stable rates since the Second World War, and when the Bank of England set the bank rate in October 1939 and left it untouched until 1951, the cost of money was 2 per cent – four times today’s official interest rate. No-one expects such a long period without change this time, but economists and businessmen are at odds over when rates should rise and how far.
David Kern, chief economist at the British Chambers of Commerce, says: “It is concerning that there is increased clamour in the media and among some City analysts for an early increase in interest rates.” He is echoed by John Cridland, the CBI’s director-general, who says: “Interest rates should remain low to help sustain the recovery.”
Ironically, the clamour for higher rates is because of the UK’s fast-improving economy. The stronger the country’s finances, the more it can absorb higher funding costs and the louder the calls for higher rates to prevent recovery turning into boom and consumer demand pushing up prices. When Mark Carney became governor of the Bank of England in summer 2013 he thought he was helping business by indicating that rates would not rise until unemployment fell to 7 per cent. Unemployment was 7.8 per cent when he introduced this policy of ‘forward guidance’ and he did not expect to see 7 per cent until mid 2016. But by early 2014 it was clear the jobless figure had fallen far faster than his forecast expected and he has been forced to remind the markets that he did not say interest rates would rise when that target was reached – only that an increase could then be discussed. And he has added that he expects rates to stay low for some time.
Kern is keen for rates to stay at the half per cent level set by the Bank’s monetary policy committee in 2009. “We believe the MPC’s forward-guidance strategy continues to be beneficial for UK business,” he says. “Although economic growth is stronger than most people envisaged a few months ago, there is still no evidence that the time is ripe to tighten policy given that earnings are below 1 per cent and inflation at about 2 per cent.”
It is questionable how much business has benefited directly from such low interest rates. First, although the Bank’s official rate is just half a per cent, the actual cost of borrowing is many times that – even 10 per cent for unsecured loans to businesses without a flawless track-record. Secondly, many companies are cash- rich, having kept their gearing down by disposing of less-profitable units and curtailing capital expenditure to preserve resources. With borrowing so low, firms have not gained fully from historically low rates: indeed, they have suffered from low returns on the cash they hold. Business has benefited more, especially over the past year, from an increase in consumer demand fuelled by easy-borrowing – though the rates on credit cards, nevermind pay-day loans, are such an astronomical multiple of the official bank rate that it is questionable how sensitive spending would be to an increase by the Bank of England. A rise in mortgage rates could seriously limit consumer expenditure, however.
With rates so low, they can only rise and the question is ‘when’, not ‘if’. The consensus is that the Bank will move before 2016 but some economists think the first increase will come this year, rather than in 2015. Business is split. A poll of members of the Institute of Directors this year found 44 per cent thinking it likely that rates would rise in 2014 while 33 per cent think a rise this year unlikely. James Sproule, the IoD’s chief economist, says: “Opinion was divided. It is the broadening of the base of the recovery that is going to be the best guarantor of continued economic expansion. In line with the desire for a more widely-based recovery, the government is clearly eager for business to start spending its accumulated reserves.”
The chancellor of the exchequer would not be pleased to see a rise in interest rates immediately before the general election that is to be held in May 2015. The Bank of England is independent of government but many assume the governor would not court controversy by raising rates during a politically-sensitive campaigning period. That would rule out a rise in rates during March, April or May next year but it could make an increase difficult even earlier in 2015, which may lend support to those expecting a rise this year.
However, the catalyst for an increase might be outside of the UK. The United States is already trying to ‘taper’ the quantitative-easing programme that has supported the American economy through the Federal Reserve’s monthly purchases of bonds. The world has become so dependent on this economic support, however, that each stage of the taper risks causing a flow of funds out of emerging-market countries. To reduce this outflow of funds, many such countries, including India, Turkey and South Africa, have started to raise their own interest rates. If those rises succeed in attracting back Western funds, central banks in the US, Eurozone or Britain could be forced to raise their own rates to stem a flow of capital to emerging countries whose high rates offset the higher risk of investment there. The UK’s interest-rate decision could thus be influenced by events on the opposite side of the world.
“Since the Federal Reserve announced that is was starting to taper its asset purchases, long-term interest rates have risen,” says Peter Spencer, chief economic adviser to the EY Item Club, a forecasting group that uses the Treasury’s own economic model. “Ten-year gilts have edged upwards and we expect yields to continue to nudge upwards over the coming year as the recovery gains momentum.”
UK gilt-edged stock acts as a predictor of long-term interest rates – though the market can be wrong. In the 1990s, investors wanted a long-term return of almost 10 per cent because they expected interest rates to stay high. As rates fell, so did gilt yields, falling below 2 per cent in 2012. But the return demanded from government stock has risen back above 3 per cent this year, clearly indicating an expectation that interest rates will rise.
Companies would have done well to lock into long-term low rates for borrowing in 2012, but if directors believe interest rates are set to increase and keep rising, then that option is still there. A bond of, say, 10-years could not only provide finance at a lower rate than will be available in the market in the final years of the period, it provides a certainty that allows finance directors to plan ahead. Several companies have raised relatively small sums by issuing bonds that appeal to retail investors.
And for companies keen to keep their gearing low following the financial crisis, investors’ appetite for equity issues has revived. A stream of companies is planning to float on stockmarkets this year and the opportunity exists to issue shares to finance takeovers or to make rights issues to permit expansion.
But for firms with debt to refinance, or thinking of increasing their borrowings, the interest rate decision is key. Although Mark Carney chose to base his forward guidance on the unemployment rate, the target set for the Bank by the government is inflation, and early this year the annual rate of price rises eventually fell to that 2 per cent target. That would seem to give Carney potential scope for raising rates but business believes that there is not yet evidence that prices have been tamed permanently.
At the British Chambers of Commerce, David Kern says: “Businesses are concerned with inflation, so the MPC must remain committed to the 2 per cent target. It is important to avoid premature steps that could snuff out the recovery before it is on firmer ground.”
Richard Northedge is commissioning and consulting editor of Director of Finance and writes a daily blog on www.Dofonline.co.uk