Ian McCafferty: four reasons why interest rates must rise now

Raising interest rates now will help to "support and sustain" Britain's recovery while ensuring prices rise smoothly in the future, according to a Bank of England policymaker.

Ian McCafferty said Britain's "remarkable" recovery over the past 18 months suggested that pay growth was at a "turning point", and that a sustained increase in wages was within sight.

Speaking at the Institute of Directors on Wednesday, Ian McCafferty outlined four reasons for raising Bank Rate from a record low of 0.5pc and warned that even small miscalculations about the degree of "spare capacity" in the economy meant the point at which the economy could start to overheat may arrive sooner than policymakers expect.

He said raising rates now would ensure increases were "gradual and limited".

"I have argued that a small rise in Bank Rate would ensure that we act in good time, such that we can increase borrowing costs gradually, allowing consumers and businesses to adapt with minimum disruption. This, I have explained, is the best way of supporting and sustaining the economic expansion that is now well under way, while achieving our inflation target," he said.

While Mr McCafferty acknowledged that wage growth was "still benign", he said this reflected the increasing share of relatively low-paid jobs, which had pushed down average earnings.

He said the income squeeze in recent years had made consumers savvier, while the growing popularity of online shopping and low cost hotels had prompted an increase in employment in warehouses, distribution centres and discount retailers, where pay is lower than the average salary.

As the recovery became more entrenched, this was likely to "dissipate" as workers began to feel more confident about moving jobs or asking for higher salaries, which would push up pay growth. He said the recent increase in wages "may well be the turning point we have been waiting for".

"Although volatile, three-month-on-three-month annualised private-sector regular pay growth picked up to 3.1pc in September," he said. "Accelerating nominal wages, together with subdued inflation, certainly augurs well for the recovery of real incomes and, as such, is welcome news for consumers, as well as necessary to ensure a sustained recovery."

Separately on Wednesday, Robert Chote, the head of the Office for Budget Responsibility, said rising productivity was essential if British households were to enjoy stronger pay growth and higher living standards.

He said consumer spending this year had accelerated ahead of pay growth at its fastest rate in more than a decade.

"If you look at the relatively robust pace of growth over recent quarters, that has been reflected particularly in terms of the contribution from the consumer, in terms of people running down saving rather than having stronger income growth. And we've assumed that it is not plausible [this could continue]," he told the Treasury Select Committee.

"If you look at the last year, the real consumption growth has been running further ahead of real wage growth than in almost any other year over the last 15 or 20 or so. Therefore in our forecast the main reason we expect the quarterly pace of growth to slow is that you see consumer spending moving more into line with income growth, and being less driven by the sort of decline in saving you are talking about."

UK growth is projected to slow over the coming quarters, but Mr McCafferty said the current level of slack in the economy, or room it has to grow without generating inflationary pressures, was uncertain, with minor changes to employment and productivity expected to have a "sizeable impact on when slack is likely to have been fully absorbed".

"Overall, I think the risks around our central profile for slack are such that we may well see the economy return to full capacity somewhat earlier than implied by our central forecast in the November Inflation Report," he said.

Inflation, as measured by the consumer prices index, rose to 1.3pc in October, from 1.2pc in September, but is expected to drop below 1pc at the start of next year. The Bank's has an inflation target of 2pc.

Mr McCafferty argued that it was sensible for Bank policymakers to “look through” low inflation because it is driven by forces that are beyond the Bank’s control, such as falling oil prices.

"Inflation expectations remain anchored, and the weakness of wages, which in any case pre-dated the falls in headline inflation, seems to be coming to an end," he said.

Mr McCafferty has voted to raise interest rates by 0.25 percentage points since August. While Mr McCafferty did not reveal how he voted at the December meeting, his comments on Wednesday suggest that he maintained his call for tighter monetary policy this month.

Martin Weale, another external Bank policymaker, said on Monday that the economy could overheat if interest rates were left on hold.

However, the seven other Monetary Policy Committee members, including Governor Mark Carney, are expected to have voted to keep rates unchanged in December.