Why should the Bank of England hike rates when it can baby-step?

January 17, 2014

When the Bank of England decides to start hiking interest rates, it may find that its standard 25 and 50 basis point interest rate moves of old are too blunt a tool for Britain’s delicately-poised economic recovery.

Instead, UBS economist Amit Kara suggests the Bank should “test the waters” with rate hikes of 5 to 10 basis points:

After many years of an aggressive ‘shock and awe’ approach, one can reasonably say gradualism is back. To be clear, gradualism in monetary policy setting is not new. Ben Bernanke offered a strong justification for gradualism in a speech in 2004, essentially advocating an incremental approach to rate setting in the face of uncertainty. Another good example, also from the US, is the Fed decision last month to dial back its QE programme. The market was looking for an explicit tapering path, but the FOMC instead delivered a small step and a promise to take further action after one month depending on the data. Our prescription of a 5 basis point rate hike in the UK is analogous to the gradualism delivered by the FOMC.

The still-high level of debt in UK households was one reason why the BoE should opt for a gentle rate hike cycle, said Kara, who suggests this approach would be more convincing than its current forward guidance of “just words”. He also pointed to vulnerability of asset prices and markets to higher interest rates.

He also noted that the scale of changes to the Britain’s base rate has changed over the years: 25 or 50 basis point changes became common in the 1990s. Before that, it wasn’t uncommon for policymakers to move the rate by an entire percentage point or more.

There have been signs more economists are willing to think along the same lines. at least in the case of the European Central Bank.

Five economists out of 59 in Thursday’s poll on the euro zone economy thought the ECB would shave interest rates – already at a record low 0.25 percent – by a further 10 or 15 basis points.

Kara does not expect the Bank of England to hike interest rates until the third quarter of 2015 – a little later than the latest consensus of economists polled by Reuters – but when it does, it should exit with caution.

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