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BoE Bank Rate Rise: The Case for the Whimper, Not the Bang

The Bank of England must balance competing and intertwined global and domestic priorities. The longer it maintains low interest rates and high levels of quantitative easing, the larger the eventual market correction will be. Two prominent risks include asset bubble formation and the misallocation of global capital. The longer emerging markets can access relatively inexpensive finance, the greater the likelihood of future political unrest in some of the UK's largest trading partners (and their trading partners, and therefore the UK's indirect trading partners) when that capital is withdrawn. At the same time, however, increasing Bank Rate may put a damper on the UK's recovery. Rate rises will cause sterling to appreciate, making UK exports more expensive and putting further downward pressure on already low inflation. It will also increase private and public sector debt payments, dampening consumption and investment. On balance, however, control of domestic economic circumstances is usually more attainable than global ones (given the ability to, for example, coordinate fiscal and monetary policy), so given the current strengths of the UK's economy and the hidden and future global and domestic risks attendant to low interest rates, it makes sense to raise rates after the Federal Reserve in a gradual, incremental fashion. If the BoE were to raise before the Fed, sterling would appreciate relative to the dollar, reducing the UK's current trade surplus with one of the main global growth engines.

The UK's recovery has strengthened in recent months. GDP per capita has returned to roughly what it was before the financial crisis, unemployment is at 5.6%, productivity is picking up, and regular pay grew by 2.7% this year. Employment is at almost record numbers, with over 30 million individuals employed, and the type of employment has shifted from growth in part-time and self-employed work into full-time, permanent employment. The IMF predicts that the UK will be the second fastest growing advanced economy over the next 4 years, trailing only the US, and will become the fastest growing advanced economy by 2019.

These are welcome trends, and much has been achieved through effective monetary and fiscal policy coordination. At the same time, though, there are underlying global and national weaknesses that the UK faces.

Due, until recently, to coordinated accommodative monetary policy among the developed world's central banks, stock markets in advanced countries have boomed. How much of this is natural and how much of this is due to the practice of quantitative easing (which forces investors into more risky, but also more rewarding markets like equity markets) is an open question, the answer of which could be a painful one to learn (or bubble to pop).

As the Eurozone has stagnated and the pound has strengthened, the balance of the UK's trade has shifted from the EU28 to the rest of world, notably emerging markets like China. It now runs a current account surplus with the non-EU world of roughly £10 billion versus a current account deficit with the EU28 of roughly £16 billion. As advanced countries maintain tepid growth, and emerging markets slow down, the UK may find itself negatively affected by economic headwinds due to interest rate rises.

Emerging market countries, in particular, may prove increasingly volatile in the coming months as interest rate rises in the US and UK near, causing capital shifts from developing to developed markets, much like the 'taper tantrum' in the summer of 2013. Emerging market currencies will likely depreciate as a result, making UK exports more expensive and foreign imports more attractive, and likely increasing the UK's already quite substantial current account deficit.

Turkey proves a good example of this dilemma. It is the UK's 8th largest trading partner in Asia, and has seen trade with the UK increase by 68.8% since 2009. Since 2010, it has run an average fiscal deficit of roughly 2.7%, which has been financed in part by foreign-denominated, short term capital known as hot money. Over the course of 2013 - 2015, with access to relatively cheap finance, the former Prime Minister and now President, Recep Tayyip Erdogan, increased fiscal outlays and pressured the Turkish Central Bank to lower interest rates in an effort to stimulate the economy (which had slowed as its EU and MENA trading partners stagnated) in the run up to Turkish local, general and Presidential elections. Lower interest rates, although giving a boost to the domestic economy, made Turkey a less attractive market for international investors because its debt and assets offered lower returns and because the Government's actions have called into question its transparency, credibility, and ability to repay its debt (the Turkish lira has depreciated sharply, making foreign-denominated debt more expensive). This in turn has led to higher yields on Turkish bonds and diversion of government funds from public expenditure to debt repayment. Turkey therefore must either raise rates to reassure international investors (and this number will certainly be higher after the UK or the US raises their rates), but risk slowing its domestic economy, or maintain low rates, stimulating the domestic economy, but unnerving foreign investors, who will continue to withdraw capital. Both options are likely to foster further political volatility in the country, which will entrench both trends and make Turkey a less attractive trading partner, likely leading to curtailed imports of UK goods and services.

To round off the MPC's dilemma, the Bank of England is also mandated to maintain price stability, which it does by targeting 2% inflation. Inflation currently sits at 0%, but the BoE thinks that around three quarters of this is due to negative or low contributions from low energy, food, and import prices, the first two of which the BoE and the UK more generally have little control over. All things considered, the BoE had, and continues to have, a difficult decision to make. Although control of domestic economic circumstances is usually easier to achieve than over global ones, actions taken with a domestic priority in mind have global implications, which in turn affect the UK's economy. But this approach also assumes a static, monolithic global economy, which is obviously not the case. So, given the strength of the UK's economy and the hidden and future global and domestic risks attendant to low interest rates, it makes sense to raise rates in a gradual, incremental fashion after the Federal Reserve, which is something the IoD has recently called for.

Michael Martins is an Economic Analyst at the Institute of Directors

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