Tomorrow the Bank of England looks set to raise interest rates. This will be a mistake. Oxford Professor Simon Wren-Lewis and the Financial Times’ Martin Sandbu have neatly marshalled the evidence against a hike. In short—growth remains weak, inflation may be above target but that is almost entirely down to the weakness of Sterling, and despite low headline unemployment there is little sign that wage growth is about to pick up and drive domestic price pressures higher.
I set out the intellectual case for higher rates, as I think the Monetary Policy Committee sees it, last week. It looks to have become deeply pessimistic about the supply-side of the UK economy (the FT’s Gavin Jackson added the useful coda that despite this, they are still more optimistic than most about the demand side of the economy.) In the MPC’s view, spare economic capacity has been eroded and inflationary pressures will start to build at a lower rate of growth than in the past.
In effect it used to think the UK economy was capable of motoring along at 70 miles per hour before the vehicle began to shake and the ride became uncomfortable. They now think that persistent engine troubles have lowered that speed limit to around 50 miles per hour and so, despite the fact that we used to drive much faster, they are moving to put their foot on the brake already.
This is a perfectly coherent view, indeed arguments that UK productivity growth is about to rebound are increasingly based on hope rather than reason. But even if the MPC is correct on the UK’s medium term prospects, this doesn’t address a more immediate question: why now?
Why not wait a few more months? If the MPC’s pessimism on the supply outlook and relative optimism on the demand side is correct then wage growth should start to tick upwards and domestically generated—as opposed to imported—inflation will begin to rise in the months ahead. The case for taking the finger off the trigger until it is sure it’s correctly identified the target is strong.
But the reason it doesn’t think it can do that can be summed up in one word: “credibility.” And policy actions driven by the need to maintain “credibility” are rarely ideal. The markets are pricing in around an 85 per cent chance of a 0.25 per cent rise this week and to back down now would be almost unprecedented. The Bank finds itself in the position of essentially “having” to raise rates because it said it would. It has spent months doubling and tripling down on the message that it will hike in November and closed down its own room for manoeuvre.
Mark Carney’s predecessor as Governor, Mervyn King, once outlined what he called the Maradona Theory of Interest Rates back in 2005. King drew inspiration from the great footballer’s second goal against England in the 1986 World Cup.
“Maradona ran 60 yards from inside his own half beating five players before placing the ball in the English goal. The truly remarkable thing, however, is that, Maradona ran virtually in a straight line. How can you beat five players by running in a straight line? The answer is that the English defenders reacted to what they expected Maradona to do. Because they expected Maradona to move either left or right, he was able to go straight on.”
The then governor explained that central banks could pull off a similar trick:
“In recent years the Bank of England and other central banks have experienced periods in which they have been able to influence the path of the economy without making large moves in official interest rates. They headed in a straight line for their goals. How was that possible? Because financial markets did not expect interest rates to remain constant. They expected that rates would move either up or down. Those seven expectations were sufficient—at times—to stabilise private spending while official interest rates in fact moved very little.”
The crucial insight here is that monetary policy’s impact on the economy isn’t just about the actual level of interest rates but about expectations of where they will be in the future. If markets, firms and households expect rates to rise or fall in the coming months that will influence their spending and saving decisions.
Of course there is another, equally, crucial point that King did not draw out in that speech: most footballers aren’t as talented as Diego Maradona was in his heyday. For most mere mortals attempting too much fancy footwork simply raises the risk of falling flat on your face. And that’s what has happened to the Bank of England this year.
For months the Bank has clearly wanted to signal that the market’s expectations of future policy are too low. As the FT reported back in September:
“A strong body of opinion in the central bank, including the governor, believes that the economy is more vulnerable to inflation, so even a small improvement in its forecast for growth would require higher borrowing costs to stave off rising prices. But BoE officials acknowledge that they have so far struggled to get this message across to the public. Investors do not believe the bank’s hawkish rhetoric” (My italics).
With the markets failing to react to the Bank’s subtle hints that rates would (eventually) rise at a faster pace than traders anticipated, the Bank dropped the subtlety this summer and reached for its megaphone.
The results have been dismal. Markets have indeed “re-priced” their expectants of the future—but only to add in this week’s expected rise. They still expect Bank rate at the end of 2021—four years from now—to be just over 1 per cent, around 0.25 per cent higher than they expected ten weeks ago.
In effect, the Monetary Policy Committee has bounced itself into hiking this week without achieving a material change in expectations about the future.
To return to footballing analogies: this one probably counts as an own goal.