Interest rates

How Employment, Wages and Inflation Affect Interest Rates

The Bank of England considers a wide range of economic evidence when deciding whether to raise, reduce or maintain interest rates. Inflation is its primary concern, but the Monetary Policy Committee also examines employment, unemployment, wage growth, economic activity, consumer spending, business investment and conditions in the housing and financial markets. There is no longer a particular unemployment rate that automatically triggers a review or change in interest rates.

The Bank of England's Inflation Target

The Government has set the Bank of England a target of keeping the Consumer Prices Index inflation at 2%. This does not mean inflation must remain at exactly 2% every month. Unexpected changes in energy prices, food costs, taxation, exchange rates and the global economy can push inflation above or below the target. The Monetary Policy Committee aims to return inflation sustainably to 2% over the medium term. It must consider how quickly to act, as raising interest rates too aggressively could unnecessarily weaken employment and economic growth.

Why Employment Matters

A strong labour market can support household incomes, confidence and consumer spending. However, it can also contribute to inflation where employers compete for a limited number of workers and increase wages to recruit or retain staff. The Bank considers:

• The unemployment rate;
• The number of people in employment;
• Economic inactivity;
• Job vacancies;
• Redundancies;
• Recruitment difficulties;
• Hours worked; and
• Changes in payroll employment.

No single figure gives a complete picture. Unemployment may remain relatively low while vacancies and payroll employment are falling, for example, indicating that the labour market is beginning to weaken.

Why Wage Growth Is Important

Wage increases can help households meet rising living costs, but rapid wage growth can also add to inflation. Labour is a high cost for many businesses, particularly in service industries. If wages rise faster than productivity, businesses may increase prices to protect their margins. The Bank therefore considers:

• Regular pay growth;
• Total pay, including bonuses;
• Private and public-sector pay;
• Pay settlements;
• Productivity; and
• Whether higher wages are feeding into consumer prices.

A single month's wage figure will rarely determine an interest-rate decision. The Committee looks for wider and more persistent trends.

Inflation, Employment and the Difficult Balance

Interest-rate decisions often involve a trade-off. Keeping rates too low when inflationary pressure is persistent may allow price and wage increases to become embedded. Keeping rates too high for too long may weaken investment, employment, household finances and economic growth more than necessary. The Committee must therefore assess both:

• The risk of doing too little to control inflation; and
• The risk of doing too much damage to the economy.

This balance can change quickly when new economic information becomes available.

What Is Forward Guidance?

Forward guidance is communication from a central bank about how it may set monetary policy in the future. In 2013, under former Governor Mark Carney, the Bank indicated that it would not consider raising interest rates until unemployment had fallen to 7%, subject to several conditions. The 7% figure was a threshold for reconsidering policy, not an automatic trigger for a rate rise. That approach was later revised and is no longer the basis for setting UK interest rates. Modern forward guidance is generally less dependent on a single numerical threshold. The Bank instead explains how future decisions will depend on the evidence and how inflationary pressures develop.

Why Interest-Rate Guidance Can Change

Forward guidance is not a guarantee. Economic forecasts are based on assumptions that may prove incorrect. Guidance may change because of:

• Unexpected inflation data;
• Changes in energy or commodity prices;
• Wars or geopolitical disruption;
• Tax and spending decisions;
• Changes in wages or employment;
• Exchange-rate movements;
• Financial instability; or
• A sharp change in economic growth.

The Bank must retain the ability to respond to new evidence rather than follow an earlier statement when circumstances have materially changed.

The Housing Market and Interest Rates

The housing market can be affected significantly by changes in interest rates. Higher mortgage rates generally reduce affordability and may weaken demand for property. Lower rates can reduce borrowing costs and support demand, although house prices are also affected by wages, housing supply, mortgage availability, taxation and confidence. Rapid house-price growth does not necessarily mean the Bank will increase Bank Rate. Monetary policy is intended primarily to control inflation across the economy, rather than to target property prices. Financial regulators may use other measures to address risks in mortgage lending, including affordability tests and restrictions on particularly high loan-to-income lending.

The Effect on Borrowers and Savers

Interest rates are often described as a double-edged sword. Higher rates may:

• Increase payments for borrowers with tracker or variable-rate mortgages;
• Increase the cost of loans, overdrafts and credit;
• Reduce household spending and business investment; and
• Improve returns on some savings accounts.

Lower rates may reduce borrowing costs and support economic activity, but can result in lower returns for savers. The effect will depend on the individual product. Banks do not always pass Bank Rate changes on to mortgage borrowers or savers immediately or in full.

Can Interest-Rate Decisions Be Predicted?

Economists, investors and financial markets continually assess the likely direction of interest rates. Expectations can be inferred from market pricing, including interest-rate swaps and government bond yields. These expectations are not certain. Forecasts can change rapidly following inflation figures, employment reports, government announcements or international events. A widely expected interest-rate decision may already be reflected in fixed mortgage and savings rates before the Bank announces it.

Avoid Relying on One Economic Indicator

Unemployment, wages, inflation and house prices are all relevant, but none should be considered in isolation. The Monetary Policy Committee assesses the overall balance of economic evidence and how conditions are likely to develop over the coming months and years. Consumers and businesses should therefore avoid making significant financial decisions solely on the basis of a predicted change in interest rates. Personal affordability, financial resilience and the terms of the particular mortgage, loan or savings account are usually more important than attempting to identify the precise date of the next rate move.