Interest rates may rise in 2010

by Ed Bowsher on 27 July 2009  |  13 comments
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Could the Bank of England raise the base rate next summer?

A leading UK economist thinks that the Bank of England may start to raise its base rate in summer 2010, according to Bloomberg. The comment comes from Willem Buiter, who used to help set the base rate at the Bank and is now a professor at the LSE.

Given his background, Buiter's best guess is more valuable than most peoples', but even Buiter is careful to hedge his comments with caveats.

He told Bloomberg: "The Bank of England could be the first out of the stable...if it goes too early, it might abort a fragile recovery and create a painful appreciation in the pound. If too late, it may be perceived as weak on inflation."

So is Buiter right?

Buiter is right to say that it's a tough call. In fact, I feel rather sorry for Bank governor, Mervyn King. The problem is that economists say that changes in interest rates tend not to make an immediate impact. In fact, there are 'lags' which can last for as much as 12 or 18 months. The base rate was only cut to 0.5% in March and that's when quantitative easing began too, so it's too early to say definitively that either policy has worked or failed.

In 'normal' times, a bank governor can look at previous economic cycles to guide him on when interest rates should be cut or raised. But we're currently in unchartered economic territory and no one knows for sure whether Mervyn King has done too much, too little, or got it just right.

If interest rates stay too low for too long, inflation could get out of control. If interest rates rise too quickly, we could have deflation and an economic slump.

Now I don't deny that the risk of deflation has fallen dramatically since Christmas. And the risk of out-of-control inflation has risen since then. But we're still not out of the recessionary woods yet. Bad stuff is still happening. For example:

• UK factories suffered a bigger than expected drop in orders this month. It was the biggest drop since January 1992.
• Ben Bernanke said last week that the projected increase in US real estate defaults could well become a "difficult" challenge for the economy. Problems in the US affect us in the UK. 

So for me, it's definitely too early to raise the base rate yet, and I'd be tempted to carry on with quantitative easing for a while longer too. I'm far from certain about when the base rate will start to rise, but summer 2010 seems like a decent educated guess.