Global economy supplement: raise rates now

As with the United States, attention has turned to the timing of the first interest rate increase in the United Kingdom; to how far and how fast rates will rise, and what the impact on the economy will be.

The Monetary Policy Committee (MPC) of the Bank of England, which sets rates, responded to the financial crisis and the subsequent deep and prolonged recession by sharply reducing the bank’s interest rate to a historically low 0.5 per cent, and by buying £375bn of assets from the non-bank private sector, in a process known as quantitative easing. The aim was to reduce long-term interest rates, boost the money supply and support asset prices. This dramatically loosened monetary stance was fully in place by July 2012.

Earnings, when adjusted for inflation, have been falling, so it will not feel like a recovery to many people—but the UK’s economic output has now surpassed its 2008 pre-recession peak, marking the end of an unusually long slump in output, and the economy is expanding at a brisk pace, with business investment growing strongly. The pick-up in growth and confidence is particularly marked in the southeast, and in the service sector. Forecasts are for the economy to grow by more than 3 per cent this year—the fastest among the world’s advanced economies—and close to that rate next year.

As the economy returns to normal, the “exceptional monetary stimulus,” as the MPC itself has described it, is no longer appropriate. There is probably still a fair amount of slack in the economy—output per head remains below pre-recession levels—and there is little sign of inflation. But the MPC should start raising the bank rate—which it sets—from the current abnormally low level long before spare capacity is completely eroded and inflation starts to rise above target, not least because rate rises will have to begin gradually.

There is considerable uncertainty about the impact an interest rate increase will have after a sustained period of unusually low rates, particularly the effect on highly indebted households. Nor is it clear how the commercial rates faced by savers and borrowers will respond to a rise in the official bank rate. By the time the economy is running at full capacity and inflation is threatening, it will be too late to start a process that may have to proceed very slowly, calibrating the effects of higher rates as it goes. The purpose of a gradual tightening of monetary policy starting now would be to slow the economy gradually, not to stop it in its tracks.

Abnormally low interest rates are creating the wrong incentives to spend and borrow, when households still need to improve their financial position. They risk building up problems for the future. Moreover, the banking system has enjoyed a long period of easy access to low-cost funding to allow its balance sheet to repair, and financial markets may have responded to easy monetary policy by under-pricing and taking on too much risk. It is time to stop the spoon-feeding and reduce the dependency.

The MPC has indicated that the bank rate will rise gradually, and then only to a level well below its historic average. Before the financial crisis, it tended to be around 5 per cent. Mark Carney, the Governor of the Bank of England, has suggested the new normal might be closer to 2.5 per cent. There are good reasons for this in the short term, and not just from the “headwinds” the UK is facing from the eurozone and uncertainty about the world economy. The difference between the interest rate set by the bank and interest rates offered on the high street has widened considerably since the crisis began, suggesting the bank’s rate may need to be significantly lower to achieve the same commercial interest rates and economic impact.

However, that spread has partially eased back and may compress further. Moreover, there is little reason to believe the neutral equilibrium bank rate will be permanently depressed. In June, departing Deputy Governor Charlie Bean said that a rise in the bank rate to 5 per cent is conceivable in around 10 years—well within the lifetime of a mortgage. Once the bank starts to raise the interest rate, the MPC has said that it will review its quantitative easing programme. It has already stopped adding to it. Allowing the programme to decline gently over time would effectively tighten monetary policy and relieve some upward pressure on the bank rate.

One thing that should not be a prime factor in the decision on interest rates is that British and media obsession: house prices. Of course, housing and house prices matter hugely; any government with a social conscience would want to ensure its population is adequately housed. There are legitimate grounds for involvement: in the demand for and supply of housing; in land policy; regional policy; consumer protection and financial education; and to ensure financial stability. But house prices are not primarily a matter for monetary policy, which should be concerned with the economy as a whole rather than with one price within it. To target house prices with interest rates could lead to a considerable and unwarranted loss and volatility of output, income and employment. House prices in any case appear to be slowing, on the back of the Mortgage Market Review, the Bank of England’s new capabilities and demand and supply factors, including a tendency for more people to live together. If a modest rise in the bank rate towards the new normal were to have a significant effect on the housing market, far from a reason for not acting, it would be evidence of imprudent mortgage lending and unsustainable house prices.

UK monetary policy is on an extraordinarily loose, emergency setting. The MPC should start to tighten now, in response to faster growth and a return to normality in the UK economy. Fears of a future sharp global slowdown or renewed financial market volatility should not be a reason for not acting now. Rather, higher rates would give more room to cut in response to any future deterioration in conditions. To start to raise the bank rate well before next year’s general election would also avoid any suspicion that politics may be influencing policy.

Rates will have to be moved in small steps, at least initially; the MPC should bite the bullet and get a move on.