12 November 2015
Missed opportunities
by Frank O’Nomics
The Governor of the Bank of England, Mark Carney, has been pilloried by some as being Mr Flip-Flop regarding UK interest rates. Having prepared the City for a rate rise via so-called “forward guidance”, the latest Bank of England Inflation Report suggests that rates could remain on hold until 2017 at least.
The whole point of forward guidance is to allow businesses to prepare for rate movements and last week’s change may mean that many will have missed investment opportunities that the lower rate outlook would have encouraged them to take. However, the issue may not be one of inconsistent messages, but more a fundamental mistake in not raising rates when they had the opportunity.
The Bank sets the level of rates at a level consistent with a medium-term objective of 2% inflation so, with inflation forecast to be below 1% until the second half of next year, keeping rates at 0.5% would appear to make sense. However, the maintenance of very low interest rates continues to invite the building of ever greater, and ultimately unsustainable, corporate and personal debt. The very machine which was developed to safeguard our economic well-being could become its nemesis.
It is a long time since Samuel Brittan wrote several books on the workings of the UK Treasury, criticising the Stop-Go economic policies of the 1960s. Then successive governments reacted like Pavlov’s dogs by raising rates when the economy was over-heating, rather than looking for the signals that could allow them to pre-empt such developments. The theory has long been that, by using forward-looking economic leading indicators, economic cycles could be smoothed, with boom, bubbles and busts avoided. This was seen to work well through what Mervyn King described as the NICE (non-inflationary consistently expansionary) era, but the extension of a period where rates have been very low for such a long time seems to have led to a re-adoption of the use of lagging economic indicators as a gauge of the state of the economy. In particular, the US and UK have both focused on labour market data, which typically lags true movements in the economy by at least 6 months and often by much more.
By using such data as a determinant of policy changes, Central Banks run the risk of doing too little too late. .Already we can see signs of wage growth developing in the UK and the US and, with skill shortages evident, this could be difficult to suppress. UK unemployment has fallen from over 8% in 2012 to 5.4%, and is expected to fall further. The Bank see the long-term equilibrium level of unemployment to be 5%, but waiting for this level to be achieved would seem to be too late in terms of containing demand and wage inflation. Last week’s Inflation Report notes that wage growth is picking up, but “remains some way below the pre-crisis average rate”. Perhaps more importantly they acknowledge that wage growth is running ahead of productivity. The genie is out of the bottle, and may be further stimulated by the adoption of a national minimum wage.
The Bank of England cites the situation in China and emerging markets in general as reasons to expect slower growth in the UK. This is very likely to be true, although 50% of our trade is with Europe and growth there is much more encouraging. The Chinese are taking steps to stimulate domestic demand, or at least to prop up their stock market, but the Bank’s model estimates that a 3% fall in Chinese GDP growth would knock 0.3% off UK GDP. This might well justify keeping rates on hold, but only if they were already close to a more long-term “normal“ level. The normal level of interest rates, which was generally assumed to be 4-4.5% as recently as 10 years ago, may have fallen in recent years (due to persistently low global inflation) to around 2-2.5%, but this is still considerably above the current level of rates which continue to encourage ever greater increases in private debt.
.If the Bank of England had adopted a policy of normalizing the level of rates once the extreme symptoms of the post-Lehman environment had faded, then debt would have been contained tot manageable levels and the extreme asset price bubble (particularly property and bonds) would not have been created. The Bank is now left with a potential situation where they should raise rates to contain the continuation of this asset price bubble, but are potentially forced to do the opposite due to their slavish adherence to inflation targeting, particularly if the global economic outlook is starting to deteriorate.
They would argue that they can do still more Quantitative Easing rather than cutting interest rates still further but, even assuming that the gilt-edged market could sustain further buying, this would exacerbate the asset price problem by encouraging institutions to sell bonds to buy property and equities. For households, where debt to income levels have slipped back below pre-crisis levels, there is greater scope and incentive to increase borrowing, particularly for property purchase. The Bank will be left trying to manage a deflation of the bubble or be seen as perpetuating a Madoff-style Ponzi scheme. The problem then is not that the Bank is refusing to increase rates now – the global backdrop would support their inactivity – but that they missed the opportunity to raise rates when they could have done so.
Consider also a different scenario, which again becomes possible as a result of the use of lagging economic indicators. UK inflation has remained persistently low, dipping again to a negative level for annual CPI in the most recent inflation data, largely due to low energy prices and a strong currency. Neither of these factors will last indefinitely. Oil prices have fallen 14% since the last Inflation Report in August. Such falls may not be sustained and, even if oil prices flat-line at current levels, base effects will mean that inflation will rise in time – low inflation would require energy prices to continue to fall; a situation that the geo-political situation and OPEC will mitigate against. As for sterling, the currency has been strong because economic growth has been robust in the UK and a rate rise (and hence more attractive returns from sterling assets) has been expected. Without these potential returns, the demand for sterling is likely to fall and the prospects of imported inflation to rise. One member of the MPC, Ian McCafferty is concerned about the path of domestic costs and hence recommends a rate rise of 0.25%. He is, however, alone among the nine-man committee.
There are good reasons not to increase rates at this point, particularly given the high level of global economic uncertainty resulting from events in China. However, we have crisis-level interest rates at a time of steady economic growth and a normalisation now will both create scope to act in the future and help to counter an asset price bubble that gets ever worse. The US seems to appreciate this and looks likely to act in December – as ever using the same lagging indicator, the falling level of unemployment, as its justification. The UK should do the same.
