Why the case for an increase in interest rates is anything but clear cut

Mortgages payments are set to rise following an increase in interest rates by the Bank of England.

Mortgages payments are set to rise following an increase in interest rates by the Bank of England. Picture: Getty Images/iStockphoto - Credit: Getty Images/iStockphoto

The Bank of England’s decision to raise interests comes as little surprise – but the case for an increase looks highly questionable.

True, the latest data on economic growth was slightly stronger than expected, with GDP rising by 0.4% during the third quarter, but this hardly represents the kind of “overheating” which would normally be expected to result in a rise in rates.

Also, although it is well above the Government’s 2% target, the current inflation rate of 3% is still well short of two previous spikes seen since the financial crisis of 2008.

On those occasions, Bank of England policymakers took the view that increasing rates would threaten economic growth and that the factors behind the rise in inflation would naturally unwind. This proved correct, with inflation even falling briefly into negative territory two years ago.

With the increase in inflation over the past 12 months being largely attributable to the rise in the cost of imports, due to the fall in the value of the pound since the Brexit vote, there is good reason to believe that inflation would have again fallen back without a rise in rates.

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It would be different were there any sign of wages starting to follow prices higher but, in fact, annual growth in pay is continuing to lag well behind inflation.

There is, it is true, some evidence of consumers responding to this by borrowing more, in order to make ends meet or to pay for luxuries, and the Bank of England has, rightly, expressed concern over the level of household indebtedness.

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However, seeking to address this through an increase in interest rates is something of a blunt instrument. If the lessons of the last financial crisis have been truly learned, the bank should be intervening to control lending in a more targeted way.

The truth is that the recent warnings from Bank of England governor Mark Carney and other members of the bank’s rate-setting committee of an early increase in rates became self-fulfilling.

The markets factored in a rate rise, so supporting the value of the pound, and had the bank confounded this expectation sterling would have gone into reverse once more, so adding to the inflationary pressure.

Having been accused of over-reacting to the Brexit vote by cutting rates, to head-off an expected slowdown which did not materialise, it might be argued that it is now prudent for the bank to reverse the cut.

But its talk of two further increases to take the base rate to 1%, even if phased over two to three years, sounds premature give the continuing uncertainty over the outcome of Brexit - and the fact that a generation of borrowers has grown up with no experience of anything other than rock-bottom rates.

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