No guarantee Bank of England can pull off plan for gradual rate rises
LONDON (Reuters) - The Bank of England is hoping it can gently wean Britain's economy off record-low borrowing costs, but its plan for "gradual and limited" rises in interest rates might prove harder to pull off than investors expect.
So far, financial markets agree with BoE Governor Mark Carney's reassurances that a return to more normal-looking monetary policy will probably not be a painful one.
Speculation, instead, is focusing on the shorter-term question of whether the Bank's first rate rise since 2007 will come in November, February or even May.
Yet there are a host of scenarios that could require the Bank to step up the pace of rate increases, such as a further run-up in house prices or an inflationary surge in pay.
"At some point their hand may be forced by events," said Andrew Sentance, a former BoE policymaker who has long called for higher rates. "There is a degree of inconsistency in pushing off interest rate rises as long as you can and still saying they can be done gradually."
Britain's economy looks set to enjoy its fastest growth in a decade this year, beating all other major advanced economies, and unemployment has fallen to a five-year low of 6.4 percent.
At the same time, though, output has only just recovered to pre-crisis levels and wage growth is painfully slow. Inflation is also below the BoE's target and forecast to stay there, making many observers confident that interest rates are set to stay low for the long term.
Carney says the "new normal" for British interest rates is around 2.5 percent, about half their level before the crisis, and in a newspaper interview on Sunday he said the economy and banks are not yet back to full strength.
Certainly there are strong reasons to expect rates to be lower than before. Greater caution from lenders means that there is a bigger gap between official BoE rates and those charged by banks, making effective interest rates higher.
High household debt levels combined with years of weak wage growth mean that household finances are more stretched than before the crisis. A rise in borrowing costs may thus have a bigger effect on consumer spending than previously.
Moreover, the U.S. Federal Reserve's caution about raising rates, combined with economic stagnation in the euro zone, suggests little upward pressure on BoE rates from abroad.
However, investors seem to give little weight to alternative scenarios that could require rates to rise faster from their record low of 0.5 percent, where they have been since 2009.
Five-year British government bond yields GBT3T19= have hit a nine-month low of 1.74 percent, reflecting global economic worries more than Britain's medium-term interest rate outlook.
Markets expect the BoE to raise rates by less than a quarter of a percentage point every three months after it starts to tighten monetary policy early next year - an outlook that was broadly endorsed by Carney last week.
Economists expecting an early rate rise were surprised by Carney last week when he suggested that the Bank was in no hurry to change policy and that it was focused on the prospects for wages - by far the weakest part of Britain's economic picture.
"This bias to 'low for longer' increases the likelihood that GDP ... will again outpace the consensus and reduces the likelihood that tightening will be anything like as gradual and limited as markets currently expect," said Michael Saunders, chief UK economist at Citi.
EXPECTATION, NOT GUARANTEE
Carney and the BoE have said that the gradualist approach to rate rises is an expectation, not a guarantee.
While stronger than expected growth is one possible cause for higher rates than markets have penciled in, another would be if the labor market once again defies BoE forecasts.
Price pressures in Britain have so far been muted, with wages staying low despite robust growth and falling unemployment.
The BoE expects wages will pick up in 2015 and 2016, but not by as much as their long-term average. That is partly because it thinks the number of people wanting to work will hit new highs.
The inflation impact of higher wages will be reduced further by a pick-up in workers' productivity, but that is something the Bank has been predicting almost since the start of the crisis.
All these pieces need to come together for Britain to enjoy strong growth and low inflation, which would enable gradual and limited monetary tightening. Yet the BoE - like many others - has struggled to forecast labor market trends over the past year, failing to predict the big fall in unemployment.
"It could be that their earnings numbers translate into stronger cost increases than the BoE thinks. In that case, the pace of (rate) increases would be greater, without any doubt at all," said Brian Hilliard, chief UK economist at Societe Generale.
Another risk is that the BoE has to raise rates to curb risks from house prices, which have jumped 10 percent in a year.
This would be a last resort for the central bank, which has said it wants to stop household debt from reaching dangerous levels by imposing curbs on how much banks can lend and to whom.
But the track record of such controls in other countries is mixed. They often put only a temporary brake on rises in house prices - especially when, as in Britain, planning rules make it hard to build new homes to meet demand. [ID:nL6N0O540L]
Sentance, who now advises accountants PwC, said the best way to stem such risks would be to raise rates now, and that some firms he speaks to are worried about the policy outlook.
"There is an increasing concern ... that we might not be getting this part of the management of the aftermath of the financial crisis right," he said.
(Editing by William Schomberg and Susan Fenton)