Carney New Normal Sees BOE Key Interest Rate at 3%: U.K. Credit

The Bank of England will limit how high interest rates increase when officials begin tightening policy as they seek to protect indebted households from derailing the economy, according to a survey of economists.

The Monetary Policy Committee led by Governor Mark Carney will probably keep the benchmark rate around 3 percent once the economy has returned to more normal conditions, 2 percentage points lower than the pre-crisis average since the BOE got independence in 1997, according to the median of 27 estimates in a Bloomberg survey. Carney last week signaled he’s in no rush to increase the key rate, currently at a record-low 0.5 percent.

“It’s a debt issue,” said Ross Walker, an economist at Royal Bank of Scotland Group Plc in London. “The household sector in particular still has very high levels of debt. It would not be able to withstand what we would have thought of before the crisis as appropriate levels of interest rates.”

Six years after the recession began, Britain is on track to lead Group of Seven economies this year. While unemployment is falling, consumers are heading into the recovery burdened by debts and lower savings, giving them less of a cushion to absorb the effect of higher borrowing costs.

Lower BOE rates are needed after the financial crisis, which prompted banks to increase the interest premium they charge businesses and consumers on loans. The average premium charged on a two-year fixed-rate mortgage with a 75 percent loan-to-value ratio was 1.87 percentage points above the BOE’s benchmark rate in January, up from 0.32 percentage point in July 2007, BOE data show.

Rate Risk

For policy makers, the risk is that increasing rates will derail the recovery in an economy where household debt including home loans has increased to 1.44 trillion pounds ($2.41 trillion), the highest level since records began in 1993.

“The BOE will tread very, very carefully when it comes to rates,” said Stuart Green, an economist at Banco Santander SA in London. “There’s a broad consensus across the market that the neutral level of interest rates, given the level of debt outstanding, would be somewhere close to 3 percent, rather than 5 percent.”

Publishing the BOE’s quarterly Inflation Report last week, Carney said rate increases, when they come, will be “limited” and “gradual.” Even when the economy has returned to normal, the appropriate level of the key interest rate “is likely to be materially below the 5 percent level set on average by the committee prior to the financial crisis,” Carney said.

Debt Concerns

The ratio of household debt to income “remains well above its pre-crisis average,” the BOE said. “And concerns about debt probably still weighed on some households’ spending in recent quarters.”

BOE policy maker David Miles said in a Bloomberg interview yesterday that while the amount of slack in the economy means there’s no case for increasing rates now, consumers should be aware that rates will eventually increase.

It’s “important that there is a clear recognition by borrowers and lenders that interest rates will not remain at this level for many years to come,” Miles said. “They need to think very carefully what’s going to happen when the cost of that mortgage moves up.”

Strengthening Economy

The Bank of England’s argument that there is enough spare capacity to keep rates on hold for now received a boost today, with official figures showing inflation slowed to 1.9 percent in January, dropping below the 2 percent target for the first time since November 2009.

While Carney is trying to reinforce his low-rate message, investors have taken their cue from the strengthening economy and are buying the pound. Sterling has strengthened 7 percent in the past six months, the best performer among 10 developed-nation currencies tracked by Bloomberg Correlation-Weighted Indexes.

Government bond yields have also been rising. The 10-year gilt yield, which fell to as low as 1.61 percent last year, was at 2.75 percent as of 12:16 p.m. in London today. The yield spread over similar-maturity German bunds was 108 basis points, little changed this year.

Asked in the poll about the economic outlook, 53.6 percent of those surveyed said it has achieved “escape velocity,” the most positive response since the question was first asked in September. Economists forecast growth of 2.6 percent this year.

Property Market

Domestic demand has driven the recovery so far, with the housing market surging in the past year. Asked if U.K. property is at risk of overheating, 64 percent of economists agreed.

Walker predicts the BOE will lift its key rate to 0.75 percent in August 2015 and that the rate will be around 2 percent at the end of 2016. Green predicts an increase by the end of this year. In the Bloomberg survey, the median forecast is for the first hike in the second quarter of 2015.

On what may be the “appropriate” rate once the economy has fully shaken off the effects of the recession, forecasts ranged from 2.25 percent to 4.5 percent, with the highest prediction still 50 basis points below the central bank’s pre-crisis average.

“Central banks judge the greater risk at the moment as tightening too early,” said Richard Jeffrey, chief investment officer at Cazenove Capital Management in London. “Globally, interest rates will probably remain lower than they have been, lower than they were pre-recession. The policy backdrop is going to be lower for longer for the foreseeable future.”

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