The BoE Conundrum: When to Raise Rates

by on March 28, 2014 10:38 am BST

The Bank of England (BoE) has done a lot to separate themselves from potential interest rate hikes as the economy strengthens, despite leading market participants with forward guidance that postures differently. BoE officials do not want to increase rates in fears that an unstable economy could be toppled, but there are dangers of low interest rates – primary factor in the global financial crisis.

Low interest rates entice high-risk activity one necessarily would not take. It forces savers to seek yield and capital gains in riskier assets, which helped fuel boom and bust cycles previously. There is no incentive to save, so consumers spend. Yet, when the next recession comes around, consumers never are prepared financially for the burden. Consumer debt-to-income is at 140 percent, only 20 percent lower than before the crisis.

They also hurt banks. Low interest rates do not give banks a reason to loan capital to the private sector because they cannot make money in the process, so the lending liquidity dries up. This means little capital that businesses need to expand and move forward. This epidemic has spread throughout Europe. How do banks “remedy” this? They, like consumers, seek out riskier returns. Banks will lend out to risky parties and creates enormous credit risks, which, in turn, can topple the economy. This usually takes the form of mortgages (think 2008/9 debacle in the US).

The BoE Monetary Policy Committee (MPC) has told market participants that rates are unlikely to rise before 2015, and then increases in rates will be made in small measures. The economy in the United Kingdom has done well. Recent purchasing manager survey data suggests that the annualized first-quarter gross domestic product will near five percent.

However, the BoE should not raise rates merely on a strengthening economy but to curb the growing housing bubble throughout the United Kingdom. For instance, the central bank’s Financial Policy Committee’s assessment of risks indicated that “mortgage at loan-to-income ratios above four times accounted for a higher share of new mortgages in Q3 than at any time since the data series began in 2005.” Housing prices have soared and continuously reach new highs. Everyone gets giddy when their home values rise, but the parabolic moves we have been accustom to never end well and gravity takes over. Wage growth has been meager, so consumers must take on asinine debt loads. It causes investment firms to speculate, too.

Central banks never say they intend on hurting the economy, yet these institutions cannot help themselves put promote policies that end up doing the very thing the set out not to do. Gradual increases in rates would be the most prudent, while the market has already priced in a 25 bps move higher. However, waiting to take action will make the BoE a lot more uncomfortable then they already are.