Brexit, slowdown: a bleak backdrop for UK shift towards higher rates

By William Schomberg and David Milliken

LONDON (Reuters) - The Bank of England has chosen an unusual time to announce that British interest rates are likely to rise for the first time in more than 10 years.

The economy is growing at half its usual pace, retailers are struggling to sell to shoppers whose wages are rising slowly, car sales are falling and the housing market has lost steam. Only employment figures look strong.

On top of that, Britain is leaving the European Union in 18 months' time and the ruling Conservative Party is still split over whether to compromise with Brussels on the exit terms or risk a fight.

Even inflation, which has accelerated well above the central bank's target to nearly 3 percent, offers only a limited justification for higher borrowing costs - most economists believe it is likely to peak soon.

So the BoE has taken a risk by saying last week that most members of its Monetary Policy Committee (MPC) thought a rise was likely in the coming months.

It has long said any increases are likely to be gradual and to a level lower than before the global financial crisis.

A first rise of a quarter percentage point would only reverse a cut made after Britons voted for Brexit in June last year and take rates back to a historically very low 0.5 percent, their level for most of the decade since the 2007-09 crisis.

But the BoE is now sounding more urgent than before about raising borrowing costs because it believes Brexit is likely to impose a reduced "speed limit" on how fast the economy can grow without pushing up inflation.

It worries that Britain, at least initially, will be less open to trade, employers will have fewer workers from EU countries to hire due to a clampdown on immigration and companies are likely to scale back investment.

That, along with a push by other central banks away from their own post-crisis emergency stimulus programmes, means it needs to get on with raising rates, Governor Mark Carney said on Monday.

Many economists responded to the MPC's surprise announcement last week by bringing forward their predictions of a first rate rise to its next meeting on Nov. 2. But they are not convinced it's the right move at this point.

"The rationale for the change of our forecast has been driven by the change in the Monetary Policy Committee's rhetoric, not a change in our assessment of the outlook for the economy, aside from the admittedly very low unemployment rate," Sam Hill, an economist at RBC Capital Markets, said.

BREXIT UNCERTAINTY, RATES UNCERTAINTY

At 4.3 percent, unemployment is at its lowest level in more than 40 years and below the 4.5 percent level which the BoE has said would probably generate inflation.

But pay growth remains below inflation and there is little sign of a significant pick-up.

For supporters of higher rates, waiting for cast-iron evidence that domestic inflation pressures are rising risks leaving things too late.

By contrast, Chris Williamson, an economist at IHS Markit, said the signals coming from his firm's closely-watched surveys of Britain's services, manufacturing and construction sectors suggest the economy is more in need of a cut than a rise.

"How serious the impact of a hike will be will depend on the extent to which lenders see this as a once-and-done hike or the start of the process of material changes in interest rates," Williamson said.

One-off rate moves by the BoE are rare, and financial markets are currently pricing in two increases by mid-2018.

Rain Newton-Smith, chief economist at the Confederation of British Industry, said she expected the BoE to move slowly after making an initial increase.

"My sense is that we're talking about waiting six months to see how things bed down," she said. "They'll wait to see how the economy reacts, how investors react and how households react."

Longer-term growth factors, chief among them Brexit, were more important for businesses than the cost of borrowing, she said.

Not all business groups are so relaxed. The British Chambers of Commerce, which typically represents smaller firms than the CBI, said it was too soon to raise rates.

A quarter-point rise would add little to borrowing costs but any move now could aggravate a fall in business confidence caused by Brexit, BCC economist Suren Thiru said. "A rate rise will signal to businesses that a period of monetary policy tightening is upon us," he said. "That could influence investment intentions over the next couple of years."

Some economists think the BoE might even have to reverse course and cut rates if its first increase proves too much of a shock to households and businesses, who have grown used to borrowing costs not rising since 2007.

A survey by IHS Markit, conducted before last week's message from the BoE, showed only 29 percent of British households expected a rate rise over the next six months.

"It is even possible that the economy reacts negatively to a move later this year and the MPC reconsiders its strategy further ahead," Philip Shaw, an economist with Investec, said.

"Indeed what was already a complex outlook for the British economy and markets has just become cloudier still."

(Writing by William Schomberg; editing by David Stamp)