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Interest Rates and Inflation

Peter Hemple reports on SWAPS, rates and inflation

Speaking in Nottingham on 28th of August, the new governor of the Bank of England (BoE), Mark Carney, signalled to the markets that they are wrong to start making bets that interest rates will rise.

He reinforced the Bank's landmark 'forward guidance' pledge to leave base rates unchanged until unemployment falls to 7%. That was a clear signal that the BoE does not expect to lift them above their record 0.5% low until late-2016, even though the market is currently anticipating a move in mid-2015.

In order for the unemployment rate to reach 7%, around 250,000 currently unemployed workers will need to find a job. According to the Office of National Statistics (ONS), the number of unemployed people fell by 49,000 between Q2 2012 and Q2 2013. At that rate it would take another five years to fall to 7%.

Carney actually said that: "We will have to see the rate of unemployment fall at least to a threshold of 7% before we even begin to CONSIDER whether to raise the base rate."

This implied that base rates might actually stay at 0.5% for a very long time. Carney estimated that in order to reach 7% unemployment, over 1m new jobs will need to be created in the private sector, to balance out jobs lost in the shrinking public sector. As reported here in Property Investor News™ last month, the rise of automation in the workplace is making it increasingly difficult to keep people in their current positions so to significantly increase the number of workers could be challenging, especially considering that the EU average unemployment rate is 11% (12.1% in the Eurozone).

I ask Vicky Redwood, chief UK economist at Capital Economics, about Mark Carney's forecast for base rates. She says: "We think that base rates will stay that low for that time period also partly because we think that inflation will fall back to the 2% target rate by early next year."

Investors don't agree
The trouble with making promises is that you have to keep them and the markets are already testing Carney's resolve. In the last three months, 10-year rates on UK Gilts have climbed from below 2% to 2.9% at the time of writing. Two-year rates have risen even more since Carney made his announcement. The message is clear…investors think unemployment will fall faster than Carney does and that interest rates are going up. Carney says that there is only a 1-in-3 chance that the unemployment rate will fall to 7% by mid-2015, which is when the markets are pricing in the first rate rise. The question is 'if interest rates keep rising, is there anything the governor can do about it?' The obvious answer would be to enact more monetary stimulus buying billions more UK bonds in order to keep the rates down.

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