UNEMPLOYMENT UPDATE: Will improving inflation and employment figures put pressure on Bank of England to raise rates?

Graham Pontin

Interest rate rises: data says yes, capacity gap says no. Graham Pontin explains.

Mark Carney, the Governor of the Bank of England, this week outlined changes to the forward guidance regime, which is intended to provide clarity as to how the Bank of England will react given future economic conditions. 

As such the guidance should reinforce and bolster market expectations, so that individuals and companies react to policy announcements, and vice-versa in a way that can be anticipated by policymakers.

This improved two way interaction and understanding of future policy and economic conditions is intended to bridge the gap between the short and long term expectations about how the economy will perform.


Yesterday's unemployment figures surprised markets performing below expectations and reporting a rate of 7.2% compared to January’s  release that reported a rate of 7.1%.  On the previous quarter, however, the rate improved 0.4%, and employment remained at 30.15 million people.

 The latest data will therefore provide some reassurance to the Bank of England and support its view that there is still room for improvements in productivity and reducing spare capacity before it needs to consider an interest rate increase. Doing so too soon would threatens the recovery, by restricting disposable incomes at a time when inflation remains above wage growth and by stifling  investment and thus potentially damaging long term growth prospects. 

 Having said this, whilst general inflationary pressures may have eased and labour market improvements slowed, house price inflation (especially in London and the South East) will encourage individuals to bring forward potential property purchases to pre-empt future interest rate rise. So whilst the latest data ought to help alleviate expectations of an earlier interest rate increase, in reality those who managed to save for a deposit through the recession are unlikely to adjust their perception of the risk of a rise.

 As such, the Bank of England still has a very complex task in assessing the optimal time to signal a return to ‘normal’ interest rate conditions.

With inflation figures for January 2013 falling below target (1.9%) and employment figures out Wednesday and expected to be positive, the unemployment rate could fall below the 7% “knockout” (level) outlined by the Bank of England as part of its forward guidance at which point the Bank would consider raising interest rates. With an inflation rate that is hovering around the target rate of 2%, and data suggesting economic growth will continue to improve, there will be mounting pressure on the Bank of England to explore interest rate increases, shifting market expectations towards more normal (historic) interest levels.

While the unemployment knockout was a relatively straightforward measure which the market and individuals can understand, the new revised forward guidance is based around spare capacity and is more complex. This potentially introduces more uncertainty around whether the Bank will increase interest rates and by how much.

The Monetary Policy Committee’s view is that the economy is currently under-performing by about 1%-1½% of GDP, and that this ‘capacity gap’ needs to be eroded further before an increase in interest rates is appropriate. Spare capacity in the economy is not only wasteful but it also increases the risk that inflation will fall below the target rate of 2%. As such the Bank of England has given itself more flexibility and time before it has to consider raising rates to ensure that the economy does not overheat and high inflation take hold.

The extent of spare capacity in the economy is not easy to measure, however, and as a less well understood metric, much of the benefit of forward guidance may be lost. Additional reassurances also announced are therefore important. The Bank of England made it clear that when the base rate does start to rise it will do so in a gradual way and along an appropriate path to ensure inflation stays on target. In addition, the Bank will not look to reduce earlier quantitative easing until after the first interest rate rise occurs.

This is important to the infrastructure market because inflation expectations and interest rates have a significant effect on mortgages, savings and current account rates, and the expected return to investors. As such, the continued commitment of the Bank of England to hold down rates and ensure a future rise is gradual in nature, will help the market to keep the costs of debt down, benefiting house buyers, disposable incomes and business investment. This will further encourage investors to look at infrastructure as an alternative means of earning reasonable and sustainable returns.

Graham Pontin is senior economist at the Association for Consultancy & Engineering