Economics

The Bank of England puts its head above the parapet

It has chosen to raise interest rates—but small corrections to monetary policy are unlikely to do much good

November 02, 2017
A general view of the Bank of England, London. Photo: Stefan Rousseau/PA Wire/PA Images
A general view of the Bank of England, London. Photo: Stefan Rousseau/PA Wire/PA Images

For the first time in ten years, the Bank of England’s Monetary Policy Committee has decided to increase interest rates, from a record low of 0.25 per cent to a still weedy 0.5 per cent. There has been a good old brouhaha in the economics community over the last few weeks about this, and it is worth weighing the arguments even after the decision. While this 0.25 per cent rise is not a game-changing outcome, the Bank’s future behaviour with regard to interest rates could be, especially in relation to other things, including, of course, Brexit.

The Bank’s mandate is to keep the rate of inflation stable at around 2 per cent. As we all know, inflation is 3 per cent, but largely because of the effects of the post-referendum decline in the value of Sterling. This should wash out of the inflation data over time, unless of course Sterling were to carry on falling. On this basis alone, the question is why raise rates?

Moreover, there has been no echo of rising inflation in the labour market even though we have record numbers of people in work, and low unemployment. In the nerdy world of economics, this is captured by the flatness of what is called the Phillips curve, a tool that is designed to show how falling unemployment and rising wages are correlated. Except that in the UK and elsewhere, they haven’t been. The stagnant growth of wages suggests that full employment is not as full as the headline data suggest. The argument then runs that we should push the unemployment rate even lower, maybe to 3.5 per cent, until such time as wages finally do start to rise.

The case against this line of reasoning is that inflation may not be temporary. The UK is experiencing what is known as a supply shock. In other words, the capacity of the economy to grow at 2-2.25 per cent, as it did before the financial crisis, has gone. This is most evident in the continuing stagnation of productivity growth. We can grow employment, and we can borrow more to consume, but our potential or trend rate of growth is lower. It is as Duncan Weldon has pointed out like finding out that your vintage car’s top speed is now 50 rather than 70 mph. To the point, the mechanical issues you’d run into at 70mph (or inflation in the economy for example), now emerge at a lower speed. So the Bank’s view is that inflation will emerge earlier, if the economy’s speed limit is lower, and capacity is used up. The truth is that we don’t know, and the Bank doesn’t know. We are all guessing, and they are trying to pre-empt.

"While this rise is not a game-changer, the Bank’s future behaviour with regard to interest rates could be"
Other reasons for standing pat on interest rates have been argued too. The economy is growing at about 1.5 per cent, but demand in the economy isn’t exactly running hot. This is true, but it doesn’t negate the supply shock argument above. The solution is for the government to address the economy’s potential by framing policies to overcome low investment and mitigate Brexit, for example.

People argue that household debt is still a lofty 140 per cent of income, and extra borrowing costs would harm the sector. There’s already been a lot of publicity about non-mortgage personal debt, such as credit card, auto and student debt, that is growing at about 10 per cent per annum. This is also true, but protecting people from indebtedness isn't the Bank’s job. Though low interest rates and QE may have actually encouraged it, inadvertently, the Bank is gingerly trying to wean people away.

Interestingly, Resolution Foundation Director Torsten Bell shows that the transmission effect of higher interest rates into the housing market may be a lot less than it has been traditionally due to lower home ownership rates, a greater proportion of people owning homes outright, and more mortgage holders having fixed rate debt.

Some economists argue that higher rates would harm investment, which as the Office for National Statistics reminded us this week, is lower in the UK, as a share of GDP, than in the US and Canada, and any other major EU country, including Italy and Greece. I am not persuaded by this one at all. If low rates were as decisive for investment as is suggested, then the ONS data would look quite different. The investment slump in the UK not only pre-dates the financial crisis, but can be traced to structural factors and to uncertainty, which a small change in interest rates isn’t going to affect one way or another.
"The focus should be budgetary policies, not small corrections to monetary policy"
Indeed, I imagine that if the government were to find a fiscal rule that allowed a measured rise in public borrowing to restore some public capital spending cuts and house-building, and Brexit were to stall or stop, the investment environment would be transformed. Brexit is going to administer a negative shock, perhaps more corrosive than sudden, to the UK economy, and in my view is a proper defensive reason not to raise rates. On the other hand, it hasn’t happened yet, and the Bank may feel it is appropriate to meet a demand shock if and when it happens. In this respect, it can take a long view.

All in all then, I think the Bank’s move is neither here nor there. It is unlikely to change the economic outcomes in the country decisively, and at the margin it can send out a useful signal to those who have come to rely on rock-bottom interest rates, those that have indulged in excessive risk taking in financial markets, and companies that should perhaps have been allowed to fail or merge, freeing up loans for newer and more productive enterprises. The focus should be budgetary policies, not small corrections to monetary policy.

What happens to interest rates in 2018, and beyond, is much more important than this 0.25 per cent. We should beware though that higher rates may be a sign of concern about the UK’s economic potential, not a source of comfort about its resilience, which Brexit is liable to undermine further.