Monetary policy is viewed by many people as being dull and technical: nebulous concepts about the money supply, theoretical output gaps, expected inflation rates. This is not the sort of stuff that sets many pulses racing; the eyes of even the most well-informed consumers can be forgiven for glazing over.
But high street prosperity needs interest rates that neither constrain nor artificially boost businesses and consumer spending. It is a balance we are in danger of being unable to manage.
The United Kingdom is experiencing a double interest rate record. Not only have the Bank of England interest rates never been lower in the 321 years of the bank’s existence, February 2015 was the 72nd consecutive month of those low rates. Traditional interest rate policy has ceased to work, leaving the Bank of England to devise what officials have admitted are extraordinary measures.
What is going on and when might we see interest rates again become dull and boring?
If ever you needed convincing that economics should be considered an art rather than a science, look no further than the calculation of interest rates. Most economists depend on some sort of quantitative model to guide policy and these suggest we can wait. But the mechanistic arguments are missing the point.
If monetary policy were normal, clearly there would be no pressure to raise rates, but we are not in normal times and with the UK economy seeing solid economic growth, there must be something else that is driving policy.
That something else is the threat of deflation and the fear of a renewed crisis in the eurozone.
Commentators seem convinced that deflation means two things: that debt becomes more expensive and that consumers delay purchases as they await further price drops. The first part of this is a mathematical truism, and for a continent as indebted as Europe, something to be avoided at all costs.
But is deflation really a case of consumers delaying purchases waiting for a price drop? It seems far more likely that consumer confidence declines in response to long-term economic stagnation—just ask any southern European. In such circumstances fear comes to the fore and more and more purchases are delayed, not in anticipation of falling prices, but in the absence of optimism about the future.
In an effort to break this vicious circle, as well as to kill any renewed eurozone crisis, the European Central Bank has launched a trillion euro quantitative easing (QE) programme, following in the wake of similar programmes elsewhere. For the United States and UK at least, QE has been credited with being an integral part of their broader economic recovery: clearly the European Central Bank hopes for similar results.
Eurozone quantitative easing envisages banks lending the new cash, which means that bankers must be confident that their existing loans are solvent and that the new loans they make are equally prudent.
While recent banking stress tests may have allayed some doubts, financial markets remain concerned. Moreover, bankers remain understandably cautious about lending, which seems justified when looking at the poor macroeconomic outlook across the eurozone. And so a vicious circle ensues.
But for many policymakers, an even bigger danger is that eurozone countries will use the money to support continued deficit spending.
This will more than likely provide a short term Keynesian boost but at a cost of allowing politicians once again to avoid tough decisions. This will ultimately set the eurozone on the road to Japanese-style stagnation and eventual deflation.
European Central Bank President Mario Draghi has made it clear that QE is not, should not and cannot be seen as a substitute for the kind of structural reforms to labour and product markets that the European Union needs.
Just to make their views on the matter crystal clear, the Germans have insisted that bond purchases are made by individual central banks, not by the European Central Bank itself—an insistence that means any potential defaults will not sit at the centre, but with the problem countries themselves. So much for European solidarity. How this all plays out is anyone’s guess but that it will have a direct effect on the UK economy is without doubt.
“Fog in the channel, continent cut off,” is an apocryphal headline with strong appeal to UK Independence Party supporters, but it is a poor way to run monetary policy. So long as the eurozone languishes, there is little chance of higher interest rates, here or there.
However justified a rise in UK rates might be, fears remain that it would trigger an export choking surge in sterling. Not being a part of the euro may insulate the UK from deflation, but as far as interest rates are concerned we are not and will never be an island.
