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M&G: five reasons for higher interest rates

M&G's Anthony Doyle shares five arguments for an interest rate hike

Ahead of today’s announcement on interest rates by the Bank of England, M&G investment director Anthony Doyle shares five arguments in favour of a hike.

Doyle acknowledges that he is running ‘the risk of being called a party pooper’, but expects rates to rise ‘certainly’ before the third quarter of 2016, the Bank of England’s prediction for when the unemployment rate will fall to the 7% threshold.

The market is pricing in a hike for February/March 2015, but Doyle supposes that one could occur ‘before year end’.

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1 Asset prices bubbles are forming

‘Economic theory and real-world experience tell us that interest rates that are kept too low for too long will distort investment decisions and lead to excessive risk taking,’ notes Doyle. ‘They may also result in the formation of asset price bubbles that ultimately collapse.’

As worrying indicators, Doyle highlights 2013’s double-digit increases in house prices in certain parts of the country, the FTSE 100 coming ‘within arm’s reach of an all-time high last seen during the tech bubble’, and UK non-financial corporate bond spreads sitting 45 basis points away from their 2007 lows.

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2 Unemployment is falling quickly towards 7%

The unemployment rate has fallen from 7.9% to 7.4% over the past nine months, far faster than the Bank of England had expected.

‘We are still well above the average unemployment rate seen during the period between 2000 and 2008, but I would argue that this was an abnormal period for the UK economy,’ contends Doyle. ‘It was a NICE period – non-inflationary, constantly expanding – and is unlikely to be repeated. Arguably the UK’s natural rate of unemployment is now a percentage point or two higher than that of the noughties, suggesting less spare capacity in the UK economy than many expect. It may not be long before we start to see wage demands start to pick up, leading to rising inflationary pressures.’

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3 Inflation risks should not be forgotten

This feeds into Doyle’s third point. ‘Whilst the inflation rate has been moderating in the UK and is close to the Bank of England’s target at 2.1%, it follows almost five years of above-target inflation. Whist it is not a clear and present danger, the experience of the 1970s suggests that we cannot ignore the threat that inflation poses to the UK economy, especially as rising inflationary expectations are often difficult to contain.’

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4 The Taylor rule suggests interest rates are way below neutral

The Taylor rule, which suggests that interest rates should be adjusted according to inflation and economic output, indicates that the base rate of 0.5% is around 2.0% below its appropriate level.

‘Negative real interest rates have done the job by stabilising the economy, but is it now time to tap the brakes?’ Doyle wonders. The UK economy grew at an annualised rate of more than 3% in the second and third quarters of last year, while business confidence surveys and purchasing manager indices are also positive.

‘Of course, the Bank of England would like the other components of GDP like exports and investment to contribute more to economic growth. A rising currency wouldn’t help this. But sometimes it is difficult to have your cake and eat it too, especially if you are a central banker.’

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5 The risk of a Euro area breakup appears to have fallen

Doyle accepts that Europe still faces many problems – such as record levels of unemployment and debt, anaemic growth, and a proposed tax on savers in Cyprus – but emphasises that the monetary union has in fact been gaining members, with Latvia the latest this year, rather than losing any. Furthermore, banking regulation has strengthened and policy remains supportive.

‘This bodes well for the UK, as stabilisation in the Eurozone suggests stronger export demand, increased confidence, and higher investment in the UK from European firms. Perversely, an interest rate hike might actually improve confidence in the UK economy, signalling that the central bank is confident that economic growth is self-sustaining.’

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