23 March 2017
Moving the interest rate goal posts
The Bank of England has forgotten its mandate
by Frank O’Nomics
The Monetary Policy Committee of the Bank of England sets UK interest rates with a view to keeping inflation close to 2% over the medium-term. If inflation is forecast to exceed this target at a two year horizon, they are supposed to look at raising interest rates, and conversely they consider rate cuts if a serious undershoot is predicted. Any significant deviation of inflation from target (1% either way) requires a letter of explanation from the Governor, which generates one in response from the Chancellor. Why then, after nearly 10 years without a rate rise, is the Bank ignoring high and rising inflation, leaving the base rate at a historic low of 0.25%? The Federal Reserve in the US set in motion what is likely to be a series of rate rises last week. There may be some differences to the UK, not least the potential stimulus coming from President Trump’s likely tax cuts, but there are also some striking similarities in the rising level of US CPI and the steady fall in unemployment. Last summer’s UK rate cut was supposedly an emergency measure, and there is growing evidence that the emergency has not only passed, but also that there are strong arguments for material rate rises rather than just taking back the precautionary move.
Inflation, measured by the Consumer Price Index, hit a three and a half year high of 2.3% in February, up from 1.8% in January and looks set to rise much higher. The Bank of England expects it to peak at 2.8% next year, although many economists are forecasting levels in excess of 3%, which would prompt a letter from the Governor in which he would explain why this had happened and what the MPC intended to do about it (it was only last December that he had to write a letter explaining an undershoot). Some are happy to describe this as a “blip” resulting from sterling’s post-Brexit vote depreciation, but how much of a blip will it be if sterling remains under pressure? The bigger problem is that price rises will prompt wage increases (real wage growth is currently negative), thereby provoking an inflationary spiral. Further, the currency factor is not the only driver, with signs that the price trend in commodities has turned up again.
Those who insist that interest rates should remain low will add to the argument of inflation being transitory, concerned by the prospect of a slowdown in consumer spending that could result from the uncertainty that surrounds our departure from the European Union. This is a reasonable stance to take – just because there has not been a loss of confidence so far does not mean that it won’t happen. However, there are strong justifications for starting to “normalise” the level of interest rates. The emergency cut in rates last summer was justified by the imminent danger of a sharp economic slowdown. The MPC was particularly concerned by low readings from forward-looking indicators such as purchasing managers surveys. Not only were these fears not realised (the PMI data turned back up quickly) but the actual growth numbers came out surprisingly strong, at 1.8% for 2016 overall. The combination of this, together with the strong CPI data, suggests that, at the very least, the August rate cut should be reversed.
Beyond this there are sound economic arguments for pushing rates up further. If we have an environment of normal, or long-term trend growth, then shouldn’t we have a “normal” level of interest rates? This would point to a level closer to 2% rather than the current 0.25%. Two former members of the MPC have been articulating their concerns that low rates are causing problems for the economy. Dame Minouche Shafik has expressed concerns that low rates may be depressing productivity and last week Sir Charlie Bean (who is now with the OBR) said that low cost credit was allowing the survival of “zombie” firms which suffer from low productivity. Phillip Hammond is keen for improving productivity to become the engine of growth in the UK, but this will be difficult to achieve unless higher rates force weaker firms out of business. The only concern is that, as these firms fail, they take some stronger businesses with them. The growth of consumer credit would further suggest that, from the point of view of household finances, people need to be discouraged from increasing debt to a point that they will struggle to repay or service it once rates finally rise.
There are others who argue more strongly for a rate rise, with four of the eight members of the Institute of Economic Affairs Shadow MPC (which meets quarterly) recently voting for a rate rise. Only one member of the MPC proper voted for a rise last week – Kristin Forbes – and sadly she will be leaving the committee in June, but this was the first time since June last year that the committee has not been unanimous. One can only hope that someone who is mindful of the MPC’s mandate, and forceful enough to remind his or her new colleagues, will replace her.
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