By Chris Giles and Claire Jones
The Bank of England believes the UK economy is recovering so quickly that it is likely to consider raising interest rates from their historic lows as early as this time next year – 18 months sooner than expected.
On Wednesday the BoE unexpectedly brought forward its forecast for when it thinks unemployment will fall to 7 per cent, its threshold for considering whether to start tightening monetary policy.
If the BoE raises rates next year it would be the first major central bank to start normalising monetary policy in the wake of the “Great Recession”.
Although the US Federal Reserve has signalled it will start slowing its quantitative easing programme, it has not yet reached the point of interest rate rises; last week, the European Central Bank cut its main interest rate to 0.25 per cent amid fears of deflation; and the Bank of Japan has embarked on a large expansion of QE.
In its quarterly forecast yesterday, the BoE’s Monetary Policy Committee said there was a 50-50 chance that unemployment would fall to 7 per cent in the fourth quarter of 2014. That is a big change from its August forecast, which implied unemployment would remain above the 7 per cent threshold until the summer of 2016
The point when unemployment falls below the threshold has been dubbed a “way station” on the road to recovery by Mark Carney, BoE governor, and will mark the moment when the BoE drops its policy of not considering any immediate tightening.
In August, Mr Carney introduced “forward guidance” to signal to markets and the public the date when the BoE expects to raise rates.
At the time, he said there was a high chance that unemployment would stay above 7 per cent until the middle of 2016. But yesterday’s forecast implied unemployment will fall below the threshold much sooner, although the BoE was at pains to point out it has not committed to tightening when the UK passes this milestone.
The MPC’s inflation report painted a rosy economic outlook for the UK with higher-than expected growth and lower inflation. If the BoE continues to forecast price rises at or near to its 2 per cent target, that would give Mr Carney the room to keep monetary policy loose even after unemployment falls below 7 per cent.
“For the first time in a long time, you don’t have to be an optimist to see the glass as half full. The recovery has finally taken hold,” Mr Carney said.
Sterling rose about 0.5 per cent against the dollar, the euro and yields on 10-year gilts climbed, and market expectations for a rate rise moved forward to the summer of 2015.
Coalition ministers know the strengthening economy could create a problem for households if interest rates rise faster than expected but some say this is a better outcome than a sustained downturn.
Ed Balls, shadow chancellor, said that while the economy was picking up, this had not yet fed through to the pockets of millions of families.
“As the governor is rightly warning, prices are still rising faster than wages and new figures today show working people are on average £1,600 a year worse off since David Cameron came to office,” he said.