Are you an:

Don't let the labels put you off!
If you're not an investor, but you want to learn, you can select investor


Register for FundCalibre!

We just need to know
if you are an:

Don't let the labels put you off!
If you're not an investor, but you want to learn, you can select investor


10th February 2016

Mike Amey, managing director and portfolio manager at Elite Rated Provider for Bonds, PIMCO

Mike Amey, managing director and portfolio manager at Elite Rated Provider for Bonds, PIMCO

Will the UK raise interest rates in 2016?

Monetary policy is something we all talk about without perhaps realising it. In simple terms it refers to the actions taken by a central bank to control a country's or region's supply of money in an attempt to keep the economy, inflation (the amount by which goods and services are increasing in price), unemployment numbers and currency on an even, positive keel.

This ‘control’ is usually in the form of raising or lowering the interest rate (the bit most of us are interested in as it affects the price of our mortgage), buying or selling government bonds and changing the amount of money banks are required to keep in their vaults.

We often hear about monetary policy being expansionary (loosening) or contractionary (tightening). The former is when the money supply is increased, for example by lowering interest rates and therefore making it cheaper for consumers and businesses to borrow, and the latter is when the money supply is decreased, for example by increasing interest rates to engineer the reverse effect.

Here, Mike Amey, managing director and portfolio manager at PIMCO, discusses the issues facing the Bank of England as it contemplates increasing interest rates. PIMCO is an Elite Rated Provider for bond funds.

“As we look forward to 2016, once again we are faced with the question of whether the Monetary Policy Committee (MPC) at the Bank of England (BOE) will finally raise interest rates, or whether this will prove to be another year where expectations for a move in official rates are to be dashed.

“Now that we have confirmation of monetary policy divergence from the UK’s two largest trade partners, the eurozone and the U.S., the question of UK monetary policy becomes ever more interesting.”

Read more: Five reasons European markets could beat the US in 2016

Our economy is in good shape

“On the one hand our economy is continuing to perform well – growth is reasonably strong, employment is at a record high, the banking system has been restructured and public sector borrowing is moving back to more manageable levels.

“However, lingering doubts remain about the path of inflation. At the moment the headline rate is hovering around zero, and underlying inflationary pressure still looks relatively weak. Will the dominant influence at the MPC be skewed to slowing the economy, or will concerns over the persistently low level of inflation win out?

“The arguments for increasing interest rates are familiar ones. Our economy continues to perform well. We expect growth in the UK of 2%–2.5%, driven in large part by resilient consumer spending and business investment. That, in turn, should spur further employment growth and, with the unemployment rate already just 5.1%, we should expect wages to increase, as the pool of available labour shrinks.”

Read more: Finance and investment wrap – February 2016

Low inflation

“So what about the risks that inflation continues to undershoot? When looking at inflationary pressures, given that food and energy prices are set internationally, it is often useful to look at inflation excluding these two sectors to get a sense of how much domestically generated inflation there is in the economy.

“Here the news is still, at best, mixed. The consumer price index excluding food and energy prices is just 1.4%. Additionally, the recent levelling off in wage growth presents the risk that they do not rise as expected, and that the previous relationship between the unemployment rate and wage growth no longer holds. In this case we could see sub-par inflation for even longer than we expect.

“The first thing to note is that the MPC is tasked with delivering 2% inflation over the medium term, with a tolerance band of 1–3%. At present, the BOE’s own forecast is that it will return to 2% by the end of 2017 and continue rising gently thereafter.

“So in theory, given the lags between a change in monetary policy and changes in inflation, this data should encourage the MPC to increase interest rates as early as the first half of 2016. However, given that inflation has persistently surprised on the low side, it would be a brave committee that takes that action! The challenges facing the MPC are akin to those of the European Central Bank (ECB) – namely a single target (inflation), which is still stubbornly low.

“On the other hand the MPC faces the same challenge as the U.S. Federal Reserve (Fed), which is that while current inflation is low, given the strength of the economy and the leads and lags involved in tightening, now would be a good time to consider taking such action.”

Read more: The outlook for US equity income funds

Sitting on the side-lines

“That is why we expect the MPC to sit on the side-line until late 2016 at the earliest, when they will have more data and the picture becomes clearer – in effect taking the middle ground between the ECB and the Fed.

“When considering the implications for markets and the risks around MPC action, there are two data points worth noting. The first is that current market pricing is for the MPC to start to raise interest rates in the first few months of 2017, with an additional 1% of hikes over the following three years. That would leave Bank Rate at 1.75% by 2020. Whilst the cumulative cycle seems plausible, the start date seems late.

“As ever, there are risks. In particular, the second half of 2016 is likely to see the UK Referendum on membership in the EU. At present, the polling suggests a close vote and, whilst our central expectation is for a vote to remain in the EU, there is clearly a significant chance that the vote goes the other way.

“Given the uncertainty that would ensue, it would be hard to see the MPC embark on a tightening cycle at or around the referendum, especially if the vote is to leave.

“In effect, both the market and the MPC are caught between two opposing forces: econometric models suggesting that inflation will increase in time, to which the prudent policy response would be a gradual tightening of monetary conditions, and the hard data suggesting that prior relationships between growth and inflation may be less robust, which would warrant caution on a policy tightening cycle.

“Fortunately this set of circumstances affords the MPC time to see how the economy evolves before acting. Our expectation is still that in due course we will see higher UK interest rates, but the countervailing forces should not be dismissed.”

Read more: The importance of income

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Mike's views are his own and do not constitute financial advice.

Sign up to receive our free weekly newsletter.