UK Base Rates
It is highly unlikely that the Bank of England would raise interest rates until after QE has finished. And then only after a pause to see how money and bond markets, lending and sterling react.
There are three monetary tools in use: interest rates, or the price of money; QE, or the quantum of money; and sterling, or the price of international activity. Currently the Bank is using all of these, and it is unlikely to stop using them all at once. In all probability base rate rises will occur last of these.
The market was hoping that QE would not be extended as it would signal confidence in the economic rebound; however Mervyn King has been consistently more cautious than the market. After the inventory drawdown and precipitous drop in output, it was likely that there would be a sharp bounce. Low interest rates have given consumers and cash-strapped businesses a stay of execution, but their overextended financial position must still be corrected. Behind the headlines of a better housing and mortgage market, we can see that discounts at auctions are widening, numbers of people with negative or low equity in their homes are increasing, and unemployment continues to rise. This is a fragile situation.
Demand growth in the UK will remain muted for a long time, therefore the increase in exports that can result from weak sterling is very desirable.
If the Bank raises interest rates too soon the housing balance will shift in the wrong direction and sterling will probably rise. Neither of these outcomes is desirable for a tentatively strengthening economy. Policy makers remember the travails of Japan.
Base rates should not rise before next year.
Then the matter will be further complicated by the election.
After the election fiscal policy must tighten, which must result in continuing loose monetary policy. Base rates may rise a little, but they will remain historically low until at least 2012. By historically low we mean below 3%.
August 2009