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What would an interest rate rise mean for UK consumers?

08 August, 2014Ivan Cohen

In 2007 the world experienced a major financial crisis which led to a long and lingering global recession. One of the responses to dealing with the problems of that ""Great Contraction"" was a form of expansionary monetary policy by central banks known as Quantitative Easing. Such measures have enabled interest rates to remain at or near historic lows for several years.

With many economies now having cleared the recessionary hurdle, and experienced GDP growth over the past year or so, discussion has turned to the timing of when interest rates will rise: not if, but when. On Wednesday the governor of the Bank of England, Mark Carney, indicated that the Bank would be likely to raise interest rates sooner rather than later. However, he noted that this remained a difficult decision. His main concern was the preference of people in the UK to continue paying their mortgages, if necessary cutting back on other expenditures.

For many people in the UK the mortgage is the single biggest component of the monthly spend. A rise in interest rates from the Bank would quickly raise mortgage rates, which in turn could choke off consumer demand for many other items, in turn threatening economic growth. Carney argued that the UK economy is “particularly sensitive to interest rates”.

If the Bank of England is to raise interest rates there are other, possibly secondary concerns. The first is what is happening to the underlying trend in inflation? The main task of any central bank is price stability, although the Bank of England has recently also undertaken to balance this with economic growth (much like the Fed in the USA). The yield curve for the UK suggests that there has been no significant increase in expected inflation. Indeed, between July 10th and 22nd the UK yield curves have moved slightly down. Until there is strong evidence of increasing inflation in the system the move to raise interest rates needs to be postponed. Some evidence towards this would be the GDP gap: the difference between actual GDP and potential GDP. Oxford Economics recently estimated the UK GDP gap to be around 4.5%, so the economy is operating significantly below its potential.

Yet Mark Carney on February 12th stated: ""The Committee’s (MPC) overall assessment is that spare capacity of 1–1½ % of GDP remains concentrated in the labour market."" Either way there remains spare capacity in the UK economy, with room for more growth before inflation pressures rear their ugly head. The second relates to the regional disparity with which UK growth has been transmitted.

While raising interest rates might help moderate growth (and thereby reduce inflationary pressures) in the more prosperous south-east of England, it could have seriously deleterious effects on the less prosperous regions of the UK, increasing the already-worrying levels of unemployment in those regions. At a time when Scotland is considering independence from the UK, an interest rate rise which made parts of the UK less well off could also see them clamour for their independence from Westminster.

Dr Ivan Cohen, Lecturer, ifs University College