Where next for UK and US interest rates?

IT has been a turbulent start to the New Year for the global economy and financial markets. Falls in the Chinese stock market hit share prices worldwide. The oil price has continued to drop, and tension between Saudi Arabia and Iran are rising. Forecasts have been downbeat about the global economy. Chancellor George Osborne has warned against a “cocktail of economic risks” threatening the UK economy.

But these negatives should be put into perspective. The UK’s major export markets are the US and the rest of Europe – which make up about two-thirds of our overseas sales.

In the US, nearly 300,000 extra jobs were created in December alone. And the latest business surveys show growth in continental Europe picking up, not slowing down. Low oil prices should be good for consumers in the UK and other major western economies, bringing down the cost of energy and motor fuel even further.

So we should expect financial markets to calm down as the full economic picture becomes clearer. When they do, it is likely that attention will switch back to the outlook for interest rates now the Federal Reserve has made its first upward move. How quickly will rates rise in the US and when will the Bank of England make its first upward move?

Financial markets and economists are expecting interest rate changes to be gradual on both sides of the Atlantic. According to the charts published by the Fed in December, US official interest rates are expected to be 1-1.5% by the end of 2016, rising gradually to 3-3.5% by the end of 2018.

The outlook is not that different in the UK. Most City economic forecasters expect a rise in interest rates to about 1% by the end of this year. And by 2018/19 the official Bank Rate is expected to be 2-3%.

If we look back over the past 25 years, the UK has normally started to increase its interest rate around the same time as the US – in 1994, 1999 and 2003/4. The recent economic performance of the US and UK economies has also been remarkably similar, as are forecasts for the next couple of years. Both the US and UK economies are now into the seventh year of a recovery with growth averaging about 2% a year. Unemployment has come down to just over 5% of the labour force in both countries.

Growth and inflation in both the UK and US are projected at similar rates, with GDP rising by 2-2.5% and inflation moving back up to 2% as the dampening impact of lower oil prices fades.

Another factor supporting the prospect of higher UK interest rates is the performance of the European economy – our major export market. The leading EU economies are now picking up again, with Germany performing well and Spain turning around. France continues to be a drag on European growth but this is offset by better performance in other countries in northern and eastern Europe, such as Poland and Sweden.

Finally, the pound could well weaken further this year. It has already dropped from more than $1.50 to about $1.45 and has also fallen against the euro in the past couple of months. This will ease worries that the pound will be excessively strong. Indeed, there could be pressure to start raising interest rates to support the pound, if concerns about the outcome of the EU referendum also start to drag sterling down.

Short-term investors are not yet persuaded by these arguments. They are not expecting UK interest rates to start rising until 2017, partly because of subdued wage growth towards the end of last year.

However, the bigger picture is that the UK labour market continues to tighten. Unemployment is still falling and the level of vacancies is the highest since at least 2001. Business surveys and the Bank of England’s own reports indicate rising skill shortages. And there are signs that these are feeding through into wage increases – for example, pay rates in construction are now increasing by more than 6%.

My expectation is that UK interest rises will follow not far behind the Fed, with the first rise in the first half of 2016, followed by further increases over the next couple of years. That is very similar to the outlook for US interest rates. We should keep a close eye on monetary policy on the other side of the Atlantic if we want to know what is going to happen to interest rates here in the UK.

Andrew Sentance is senior economic adviser at PwC and a former member of the Bank of England’s Monetary Policy Committee