Normalising interest rates should be more like scaling back emergency medicine than invasive surgery; David Miles, a member of the Bank of England’s monetary policy committee, expects to vote for a rate rise in the coming months

Normalising interest rates should be more like scaling back emergency medicine than invasive surgery

David Miles, a member of the Bank of England’s monetary policy committee, expects to vote for a rate rise in the coming months

Economics professor Miles also said it was “wildly unlikely” that interest rates would return to pre-crisis levels of around 5pc Photo: Bloomberg News

By David Miles

9:00PM BST 22 Jun 2014

I was surprised to discover recently that I am shortly to become the longest-serving member of the Bank of England’s Monetary Policy Committee.

Having joined the MPC just after March 2009 – when Bank Rate was cut to its current all-time low of 0.5pc – I was also facing the prospect that I would become the first MPC member to leave the committee having never voted to change interest rates.

That might look a bit embarrassing when my children’s children asked what grandpa did when he was at the Bank of England.

I am glad to say that I think the chances of my setting this record have fallen a good deal over the past several months, a period when the recovery has come to look firmer.

It now seems to me much more likely that a normalisation of monetary policy starting at some point in my remaining year on the MPC will become appropriate. This is good news. Let me explain why.

Having Bank Rate at 0.5pc is obviously not a normal or sustainable setting for monetary policy. We have had such low rates because the economy took a huge hit in the aftermath of the financial crisis of 2008.

Until fairly recently we have not had any sort of sustained recovery from that. Now we have one.

Thankfully it is proceeding while inflation remains subdued. Following a long period when it was above the 2pc target, inflation has dropped back to under 2pc.

So the process of normalising interest rates, when it starts, looks to me likely to be one taken because of the resilience of the recovery rather than because of a need to react to excessively high inflation.

This is more a case of scaling back the emergency medicine as the patient begins their recovery, rather than invasive surgery to deal with a sudden, life-threatening illness.

This would be in contrast to many past episodes of rising interest rates in the UK which were triggered by worrying inflation news. Because the inflation outlook is benign, with both cost pressures on firms and inflation expectations of households relatively subdued, I do not think there is urgency about starting on the welcome path to a more normal setting for monetary policy.

There are signs that there is still slack, or spare capacity, in the economy – continued low wages settlements is one of them. So the stimulus given by very low interest rates is not something that has to be removed right now.

But that day is coming. When the right time will be to begin raising rates is something that reasonable people can disagree on. I suspect my reasonable colleagues on the MPC will not all see it the same way.

What is important is that this process of normalisation will not be bad news. In recent British history, rising interest rates have generally been painful for two reasons: they often started because inflation had got out of control and, partly as a result of that, they were often eye-wateringly sharp.

Between May 1988 and October 1989 interest rates went up by 7.5 percentage points. Between October of 1977 and November of 1979 interest rates went up by 12 percentage points.

On both occasions it was the problem of high inflation that triggered the very sharp rise in interest rates.

Today inflation is under 2pc and it is likely to remain subdued for some time to come.

I would make one final point. The level of Bank Rate to which we might ultimately get to at the end of a period of gradual normalisation is likely to be lower than the rate consistent with inflation being at target before the financial crash of 2008.

In the 10 years before that crisis Bank Rate had averaged close to 5pc – a position which kept inflation consistently very close to the target.

However, over that period – and particularly in the few years immediately before the crisis began in 2007 – the spread of interest rates faced by borrowers in the economy over the Bank Rate set by the MPC had fallen to very low levels.

This was most marked in the mortgage market. The average difference between Bank Rate and the interest rate on new mortgages had fallen to close to zero by the mid-2000s.

Today that spread is about 2pc on most mortgages; on some it is much higher. I think it very unlikely that the spread will fall back to close to zero.

All else equal, this will mean that the level of Bank Rate set by the MPC once we are back to normal can be meaningfully lower, on average, than the rate of about 5pc that was consistent with inflation at target before 2007.

One can put the same point a different way – the current, exceptional level of Bank Rate of 0.5pc is generating an interest rate on new mortgages in the UK that would have been consistent with a Bank Rate of about 2.5pc before 2007.

So the process of normalisation in monetary policy has less far to go than has been typical in the past.

A return to the sort of interest rate increases that were typical in my youth seems, thankfully, wildly unlikely.

David Miles is a member of the Monetary Policy Committee and a professor at Imperial College, London