Policy change on rates likely

The ‘Great Recession’ of 2008-2009 and the subsequent sluggish and uneven pace of recovery from it, has seen many central banks cut interest rates to record low levels of between 0% and 0.5%.

They have also employed non-standard monetary policy easing measures to boost economic growth. These have included quantitative easing and forward guidance that interest rates can remain low for a prolonged period.

It has been an unprecedented period of monetary easing. The weak inflationary environment and outlook for a continuation of very low inflation has allowed central banks to pursue such a loose policy.

Monetary easing is still continuing. Very weak economic conditions in the eurozone saw the ECB cut rates twice in 2013. A fall in inflation to below 1% prompted the ECB to loosen policyfurther in June and September of this year. The bank cut its key refi rate to 0.05% and moved the discount rate into negative territory. It also announced measures to boost market liquidity and bank lending, including two asset securities purchase programmes, in effect quasi-quantitative easing.

The ECB retains an easing bias and has indicated it is prepared to loosen policy further if risks grow of a prolonged period of very low inflation. ECB rates are also expected to stay at virtually zero for an extended period. Markets are not anticipating any increase in rates until the end of 2017 at the earliest, and do not foresee rates rising to 1% before end 2020.

By contrast, the US Fed and Bank of England have had to temper their forward guidance on rates staying low in the face of better economic activity and, in particular, a much faster than expected improvement in their labour markets. The Fed is winding up its QE asset purchase programme this month. However, it has indicated interest rates will not rise for a considerable time.

Meanwhile, in the UK, two MPC members have voted for an immediate rate hike at recent committee meetings. However, the majority view on the MPC is that with wage inflation falling to very low levels, CPI inflation well below target and declining, and a weak external environment, it can afford to be patient and not hike rates now. Thus, as in the US, rate hikes in the UK do not appear to be imminent. Indeed, markets have been scaling back their expectations recently on both the timing and scale of rate hikes in the US and UK, in response to a further weakening of inflationary pressures and the continuing fragility of the recovery in the global economy.

The timing of the first rate hikes has been pushed back to third quarter of 2015. Furthermore, futures contracts now see UK and US rates rising to 1.25%-1.5% by end 2016 compared to 2% or above, previously. Obviously, the recoveries in the US and UK economies will need to be sustained for rate hikes to materialise next year.

It is hard to see their central banks keeping interest rates at their very low levels is such circumstances, even if inflationary pressures remain very subdued. Rate hikes, then, seem likely in the US and UK in 2015/16, although they are expected to prove very modest. Nonetheless, it would represent an important change in monetary policy direction.

It would also imply a marked divergence in monetary policy globally, as the ECB and Bank of Japan are expected to keep rates at 0% for a long time of time.