Economists expect the Bank of England to raise Bank rate by a quarter-point to 0.75 per cent next Thursday. Historic statistics suggest this is no big deal. Bank economists have estimated that, in the past, a quarter point rise in rates reduces output by only around 0.15 per cent. That’s only a fraction of a forecast error.
So, why the fuss? One good reason is that this rate rise might do more harm to shares and the real economy than those historic estimates imply.
For equities, the danger is that it might trigger a reversal of the “reach for yield”. In recent years, low interest rates might have tempted investors into shares not because of confidence about dividend growth, but simply out of desperation for some kind of return. If this is the case, then rising rates might prompt them to switch back into cash when returns on it improve.
Of course, a small rise to a still-meagre rate might not have this effect. But if investors expect more rises, they might sell equities for fear that these would cause a reversal of the reach for yield. Also, of course, the Bank isn’t the only central bank raising rates: economists expect two more rises this year from the Federal Reserve in the US.
A further problem is that monetary policy is not merely a hydraulic process in which central bankers pull levers with predictable effects. Instead, as Andrew Caplin and John Leahy stressed in a wrongly neglected paper, it also has signalling effects.
One reason why past rate rises have had so little impact is because of this signalling effect. Companies might reasonably interpret a rate rise as a sign that experts have sufficient confidence in the economy to tighten monetary policy. A rise signals, then, that high demand is likely. This might embolden some companies to expand, thereby offsetting the higher cost of capital.
This time, however, this offset might not work. The Bank is not raising rates because it thinks the economy is booming; it expects GDP growth of only 1.7 per cent per year over the next two years. Instead, it is doing so in an effort to normalise rates. This means the usual signalling effect of a rate rise (that better times are coming) will be weaker than usual. Which means the rise might do more damage than usual.
We can’t of course be sure that this will be the case. And that’s the point. A rate rise creates uncertainty – not just about its impact on the economy, but about the path of future interest rates. And we know that policy uncertainty depresses investment. When faced with uncertainty, companies wait for greater clarity before investing or expanding.
Of course, monetary policy is by no means the greatest source of uncertainty: that about Brexit is already suppressing activity, as new research from Cambridge University shows. But it gives boardrooms yet another reason to err on the side of waiting and seeing. Which adds to the chilling effect on capital spending, exports and expansion.
In truth, the Bank knows all this. Governor Mark Carney has been saying for months that rate rises, when they come “are likely to be at a gradual pace and to a limited extent”. He’s done so in an attempt to reduce the harm to activity that a rate rise might cause. Will he be successful? We might – at last – be about to find out.
