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Can the government really keep interest rates low?

Can the government really keep interest rates low?
March 17th, 2015
Author: Ben Gosling

David Cameron’s pre-election pledge to keep mortgage rates low will strike a chord with mortgage-holding voters, but is it a promise he can keep?

Up until late last year, it seemed inevitable that 2015 would see an increase in the Bank of England base rate (BBR), and a concomitant increase in borrowing costs. Weak inflation over the turn of the year put paid to this certainty, necessitating a static or even lower rate for longer than forecast and keeping borrowing costs down for some time to come.

Mortgage rates are a concern for many households, and Mr Cameron rightly recognises them as an electoral linchpin. Speaking at ThinkBDW in Colchester on 2 March, he pledged to keep mortgage rates low if the Conservatives win the general election in May [1], [2].

But could he actually make good on this pledge if given the chance?

To answer this question, we need to understand the difference between fiscal policy and monetary policy, and how they work in the UK. Both policy sets have the same goals—keeping economic growth and inflation on-target and unemployment low—but they achieve them in very different ways.

Fiscal policy is the remit of the Treasury. It involves raising or lowering government expenditure and revenue collection (spending and taxes) in order to influence the economy. Fiscal conservatism is one of the core policies of the current government, which has cut social spending in order to reduce the UK’s budgetary deficit.

Bank of England (PD) 2Monetary policy is the control of the supply of money, usually through the raising or lowering of interest rates. By making interest rates high or low, monetary policymakers can influence whether money is saved or spent. In the UK, monetary policy is set by the Bank of England’s Monetary Policy Committee (MPC).

Since 1998, the Bank of England has been operationally independent from the UK Parliament with regard to setting monetary policy [3]. This is, of course, not clear-cut; the MPC remains accountable to the Parliament through the Treasury Committee [4], and some speculate that the current climate of low interest rates is as politically as it is financially motivated [5]. But the fact remains that the government should not be able to exert direct or overt influence over mortgage rates.

The other question we should ask ourselves is: if the Treasury could suppress mortgage rates, should it?

Early last year, Martin Weale became the first Bank of England policymaker to publicly deviate from the consensus that the BBR should remain at 0.5%. He told the Financial Times that, for the base rate to rise by no more than 1% per year, the MPC should not wait too long before increasing it [6].

At this time, the spare capacity in the economy—the difference between optimal economic output and actual economic output—was shrinking, and Weale predicted that within two to three years, there would be no slack whatsoever [7]. This would mean that the demand for goods could start to outpace supply, causing inflationary pressure.

In order to counter rapid inflation, the MPC would be forced to increase rates faster than planned. An increase of more than the expected 0.25 percentage points per quarter would rattle the markets and cause financial turmoil for the millions of households with high levels of debt.

Of course, Weale’s predictions did not account for the low-inflation environment the UK is currently in. Conveniently, interest rates will likely need to stay low for some time yet. But it will be due to economic necessity, and not government mandate, that they do.

Written by Ben Gosling for Commercial Trust Limited

References:

[1] Ray, D. “PM: We’ll keep mortgage rates low if we win.” Mortgage Strategy. 11 Mar 2015.

[2] Lodge, W. “David Cameron unveils Conservative housing manifesto in Colchester.” East Anglian Daily Times. 2 Mar 2015.

[3] Bank of England Act 1998, s 10

[4] “Transparency and Accountability at the Bank of England.” Bank of England. 11 Dec 2014.

[5] Kirkup, J. “How independent is the independent Bank of England?” The Telegraph. 19 Aug 2014.

[6] O’Connor, S. “MPS member urges UK rate rise ‘sooner’ rather than later.” Financial Times. 28 May 2014.

[7] “UK economy to hit full capacity in 2–3 years – BoE’s Weale.” Reuters. 20 Mar 2014.

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