Source: Deloitte Monday Briefing 20/07/15

Last week, Janet Yellen, the Chair of the US Federal Reserve, and Mark Carney, the Governor of the Bank of England, signalled that interest rates in the US and the UK are likely to rise by the end of this year.

The fact that Ms Yellen and Mr Carney are talking up the possibility of rate rises suggests that they believe the weak patch in US and the UK growth in the first half of the year is temporary.

As the first US and UK rate increases since the financial crisis this would mark a historic start to a process of unwinding the ultra-loose monetary policy of recent years.

Three economic indicators are signaling that the next move in rates on both sides of the Atlantic is likely to be up.

First, although currently running at low levels due to the decline in energy prices, inflation is expected to accelerate sharply next year. Economists expect UK and US inflation, predicted at 0.2% this year, to rise to 1.6% and 2.2% respectively in 2016.

Second, capacity constraints reported by businesses – a proxy for excess demand – have been rising in the US and UK. These measures are now close to their pre-crisis levels, suggesting limited spare capacity and pointing to growing inflation risk.

Finally, and perhaps most crucially, wages are rising at a significantly faster pace than inflation in both economies. In last week’s statement, Ms Yellen said that the Fed expected continued hiring to propel the US economy towards full employment – a development that is likely to exert further upward pressure on incomes.

In the UK, real wages have recovered from the longest and steepest decline since the Victorian age and are now rising at the fastest pace in five years. UK private sector wage growth, at 3.8% in the three months to May, is running close to levels considered inflationary by policymakers and further acceleration would strengthen the case for a rate rise.

So, how would a rate rise affect the economy?

Our view is that the first rate rise will signal the beginning of a very slow and cautious process of raising rates. Both central banks have repeatedly emphasized the slow pace of the tightening. Central banks fear deflation and economic weakness far more they fear inflation. The message is that US and UK interest rates are likely to remain well below pre-crisis norms for several years yet.

In a speech last week the Mr Carney noted that short-term interest rates have averaged around 4.5% since around the creation of the Bank of England three centuries ago. He suggested that in the medium term – so perhaps in three to four years – interest rates would peak at around half this level, so 2.25%.

The effects of the first rate rise on the real economy are likely to be modest, partly because they will be offset by rising wages.

The Bank of England reports that if interest rates rose by two percentage points and household incomes by 10%, the proportion of households with unsustainably high mortgage-debt-servicing costs would rise from 1.3% to just 1.8% – far below previous peaks.

Last week’s high-profile speeches by Ms Yellen and Mr Carney are part of a campaign to get business and markets accustomed to the prospect of interest rate rises. They want to avoid nasty surprises.

The campaign seems to be working. Financial markets are pricing in about 100 basis points – or 1.0 percentage point – of interest rate rises in the UK and US by the end of 2016. The 15% rise in sterling and the 17% appreciation of the dollar in the last two years partly reflects growing expectations of higher interest rates. UK Chief Financial Officers have certainly got the message. They rank higher interest rates as tying with the Greek crisis as the top external challenge facing business over the next year.

Of course borrowers like cheap money. For as long as I can remember interest rate rises have tended to be seen as “bad news”. But current levels of interest rates are a symptom of an economic system that is not working. This time we should welcome the first interest rate rises in the US and UK as taking us a step closer to economic normality.