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…