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3 Reasons to Raise UK Interest Rates Now

Economists agree the UK tops the G7 recovery. So why stick at 0.5%...?
 
THERE is growing concern about developments in the UK housing market, writes former Bank of England policy-maker Andrew Sentance on his Hawk Talks blog.
 
These were registered in the latest OECD report on the UK economy, which called for "timely measures" to stop the market overheating. Earlier this month, Sir Jon Cunliffe, the Deputy Governor responsible for financial stability at the Bank of England, described the state of the housing market as the "brightest light on the dashboard" warning of dangers ahead for the UK economy.
 
Doing nothing is not an option. House price inflation is now above 10%, according to the Nationwide. This is no longer just an issue for London and the South-East. Prices are rising throughout the country – albeit at stronger rates in the London area, which has led the recovery from recession.
 
So what are the options? The two main tools available are:
  • a rise in interest rates; and
  • targeted measures aimed to restrict lending by banks in the mortgage market.
In my view, the evidence suggests interest rates should be used as the main instrument to cool housing demand – though it may be appropriate withdraw some of the other financial support to housebuyers as interest rates are rising.
 
There are three key arguments which point to the need for interest rate rises to cool the housing market.
 
First, interest rates are extremely low at present. So there is a need to move them up to strike a more reasonable balance between borrowers and savers over the medium term. The 0.5% Bank Rate which has prevailed for the past five years is the lowest we have seen in the UK's recorded history. Interest rates were reduced to an abnormally low level to restore confidence and growth in the aftermath of the Global Financial Crisis in 2008-9. But over five years on from that crisis, a reassessment of policy is needed to align the level of interest rate with the very different state of the economy we now face.
 
Second, the UK economy is performing very strongly. The IMF, OECD and PwC all expect the British economy to head the G7 growth league in 2014. It is not just the housing market which is strong at present. There is a more general upsurge in economic activity. Business surveys are very positive – for example, last month's CBI Industrial Trends Survey recorded the strongest business optimism readings since 1973 (when the UK economy grew by over 7% – its postwar growth record). Other business surveys show a similar picture of strong business confidence and healthy growth alongside rising employment and investment.
 
A wide range of economic evidence points in the same direction. The latest car registration figures show the strongest run of monthly growth since the late 1980s. Unemployment is falling and vacancies are back to the levels we saw before the crisis. GDP growth is the strongest we have seen since the financial crisis. In other words, the buoyant housing market is not just an isolated problem. It is part of a more general picture of strong economic growth, warranting a rise in interest rates.
 
The third argument in favour of raising interest rates is that it would be much better than the alternative – restricting access to mortgage finance by various bureaucratic mechanisms. In the 1980s, we moved to a deregulated mortgage market which served the UK economy very well. Access to mortgage finance was freed from the constraints of Dad's Army's Mr Mainwairing and his equivalents in the world of building societies. The "quid pro quo" of this freer mortgage market was that the demand for housing finance was controlled by the interest rate and the cost of finance, not by bureaucratic financial rules.
 
Re-regulating and restricting housing finance is a retrograde step and will deny many first-time buyers their first step on the housing ladder. Economists favour the price mechanism as the best approach to regulate demand in markets. In the case of the housing market, this should mean allowing interest rates to rise in the current circumstances.
 
Gradually raising the official interest rate from its historical low of 0.5% seems the best place to start to keep the UK housing market in check. If this causes a surprising slowdown in the economy, then the MPC and the FPC should review and other measures might be considered. But the housing market is just one piece of evidence that the UK economy needs higher interest rates. If the MPC can't deliver this now, they will have to impose a bigger rise later.

Now senior economic advisor to PricewaterhouseCoopers and part-time professor of sustainable economics at the University of Warwick in England, Andrew Sentance is a British business economist who from 2006 to 2011 served on the Bank of England's Monetary Policy Committee. Consistently calling for higher interest rates to combat rising inflation during his last 12 months in the role – and overwhelmingly outvoted each time – Dr. Sentance today shares his views on macroeconomic and monetary developments in his weekly blog, The Hawk Talks. His previous roles include senior economist at the Confederation of British Industry (CBI), chief economic advisor to the British Retail Consortium, and chief economist at British Airways.

See full archive of Andrew Sentance articles

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