Will the Bank of England raise interest rates sooner rather than later?
That debate has once again picked up some steam on the back of strong GDP data coming out of the U.K. last week that showed a greater-than-expected improvement across all sectors of the British economy. The 0.8% growth figure recorded for the third quarter is also, in fact, the British economy’s best quarterly performance since 2010. “If the economy keeps growing as it has in the third quarter, we’d have what would be sustained growth in the fourth quarter,” said Charles Davis, head of macroeconomics at the Center for Economics and Business Research in London. More importantly, that means that “you’d be looking at the unemployment rate falling quicker than what was forecast in August,” he said, and perhaps even coming close to the stated 7% limit that would lead the Old Lady of Threadneedle Street, as the central bank is fondly known, to change the course of interest rates.
“Since August, we have seen a sustained improvement in the data, so you would think that in light of this, the Bank of England would revise their view on rates,” Davis said.
The U.K.’s Central Bank has said it would maintain interest rates where they are until the country’s employment rate falls to 7%, unless inflation becomes a major problem, and it has stated it expects this to happen in 2016.
The question now is whether the current strong state of the economy and the fact that unemployment, which is now at around 7.7%, is decreasing faster than expected and will lead to an increase in interest rates. The U.K’s Central Bank will weigh in on inflation, currently at around 2.7%, in early November and some believe there may be a shift with respect to interest rates as well.
But Bank of England Governor Mark Carney was also the first to warn about the dangers of getting too excited about the future prospects of the British economy. Although the third quarter GDP figures are encouraging, Carney said that they are coming from an extremely low base and even if unemployment has fallen and will continue to fall, it’s too early to get too excited, since the U.K. economy still faces numerous challenges, not least the recovery of the broader Eurozone.
Productivity is one of the biggest issues the British economy faces. According to data released by the country’s Office of National Statistics (ONS) in September, productivity in the U.K. is far below pre-crisis levels and also significantly less than that of other industrialized nations including the U.S., Germany and France.
“This may be because of a lack of investment and companies needing to pair workers up with more capital that they don’t have yet, and they are waiting for right moment to do so,” said Azad Zangana, chief economist at investment firm Schroders in London. “But hits to productivity could also be due to interest rates being held at such low levels that companies can pay their interest and still continue to survive. In addition, we have also had a big hit to the financial services industry. That sector is one of the big value-adds to the economy and that it has productivity levels,” he said.
Whatever the reason, the U.K.’s productivity issue is a real puzzle for economists, according to Davis, “because even though the growth in employment has been considerably stronger than expected, we have had a drop in productivity and we’re not producing as much as we were pre-crisis, though the labor market looks so much healthier compared to the rest of Europe, in particular countries like Greece and Spain,” he said. Increasing the opportunity for investment in businesses and bringing about greater vibrancy in the private sector will help a great deal in bridging the productivity gap. However, the U.K’s economy is 2.5% smaller than it was pre-crisis and after seven quarters of very poor growth, it’s not easy to get things going again, Davis said.
“In the long view, what we’re seeing is by no means an amazing recovery because in the U.K., incomes are falling and inflation is going up by a good two percentage points higher than the average pay growth, so that is still a challenge,” Davis said. The question now is whether Britain’s economic recovery can move on from the housing market and consumer spending, and toward an increase in business investment and an improved performance on the export front, according to Davis.
The direction of the interest rate and the role it plays are yet to be determined, but there are positive signs for the future of the U.K. economy, because “it looks like Eurozone will exit recession and even grow in 2014,” he said. “And whether we like it or not, the U.K.’s main export market is Europe.”