Political Promise

Why the bank must hold its nerve

In Ani Mathur on January 24, 2011 at 10:39 am

Anirudh Mathur explains why the Bank of England must hold the base rate at 0.5%

Two is the magic number. So the emergence of 3.7% CPI inflation this week was disconcerting for all, particularly given CPI has overshot the Bank of England’s 2% (± 1%) target rate for the past 13 months. This level of inflation can damage quality of life and it is important that in the medium to long term inflation is kept stable, at a roughly optimal level of 2%. Yet the seemingly startling nature of 3.7% CPI inflation should not distract us from the main risks to the UK economy at the moment: the downside risks. Whilst being on guard, the bank must hold its nerve: interest rates should not rise.

Countless arguments have been aired regarding the need for an interest rate hike to counteract the stubbornly high rate of inflation that has not yet receded, despite the bank’s previous assertions that it would recede. Firstly, it is claimed that if the bank does not raise interest rates now it discredits its mandate: its 2% (± 1%) inflation target. This would happen as inflation expectations, a key determinant of the actual rate of inflation would drift upwards. Secondly, it is argued that not to counteract the rise in inflation will result in a bigger longer-term squeeze on consumers, through higher bills and costs – damaging to quality of life. The final key reason is that starting to lower price rises later rather than sooner could result in demand by workers for higher wages now, leading to a potentially damaging wage-price inflationary spiral. Given CPI looks to head even further upwards even as things currently stand, possibly peaking at around 4.1%, further increases in inflationary pressures through an inflationary spiral must be avoided.

As we see, there are upside risks and dangers. But there are always dangers. It is important to take a step back and consider our entire position; not just from a short term perspective but a medium term to long term one too.

The greatest danger we face at the moment is not on the upside but on the downside. Recovery is weak and the deflationary spectre has not yet retreated – it could come back to haunt us.

As the Financial Times Lex column so succinctly explained it, the inflationary pressures we see at the moment, are either imported (commodity prices), one off (VAT hikes), or a mixture of both (the depreciation of the sterling since 2008). As this shows, although stubborn, inflationary pressures in the medium to long term do not reflect the seemingly startling nature of 3.7% CPI inflation, given the transitory aspect of most of the main inflationary pressures at the moment. Additionally to this, although inflation expectations are indeed rising, as measured by bond market inflation break evens, they remain manageable and below pre-crisis levels; we’re not on the slippery slope.

In contrast to this, this week’s figures regarding unemployment and particularly youth and long term unemployment are a stark reminder of the real downside risks our economy faces. The level of slack within the labour market shows that a wage-price spiral is very unlikely to occur, particularly given the way in which during the current recession people have been more willing to take pay cuts.  Growth is weakening, and our economy’s output gap is significant. This means that in actuality, output and employment are not above, but below the level consistent with stable long run inflation.  When we consider that the deflationary effects of the fiscal austerity programme have not yet even kicked in, we can see how real the risks of deflation, something to be avoided at all costs, could be. Forget slight increases in pain on consumers due to 3.7%, the effects of any deflationary spiral will be much worse: misery and mass unemployment, with the lost generations to follow.

Confidence is already shattered due to budget consolidation and a rate rise would simply further erode this, even if rates do only rise by 0.25% to 0.75%. Proponents of this marginal rise argue that in real terms, such a rise should have no massive effect given real interest rates will remain negative, it will simply signal intentions to honour the inflation target. Yet such arguments fall down to the problem of money illusion, the fact that rates are seen in nominal as opposed to real terms. Further, even if we assume money illusion will not occur, just the very signal of a rise in itself, even if marginal, could damage already weak confidence.

Instead, the Bank should talk down the current inflation, whilst making it clear that CPI inflation will rise further before it falls. Its main error so far has been to not adequately see that inflation would be this high and not adequately explain why. Yet in terms of policy it must hold rates until recovery strengthens, instead of dangerously deflating our economy to counteract imported and one off price pressures.

Economic history shows us the danger of rate rises too soon: a Japanese style lost decade and the risk of years of stagnation and pain. Forget the hysteria, monetary policy committee – hold your nerve.


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