Wanted! A strategic approach to UK monetary policy

The Bank of England Monetary Policy Committee (MPC) will consider tomorrow at its May meeting whether to raise the official UK Bank Rate to over 0.5 per cent for the first time since March 2009. The short-term indicators on growth and inflation present a mixed picture. GDP rose by just 0.1 percent in the first quarter of this year, though economic activity was quite significantly affected by wintry weather—hitting both construction output and retail sales. CPI inflation has fallen back to 2.5 percent, a slightly bigger short-term drop than the Bank of England was expecting.

Labour market indicators, however, continue to be positive. The unemployment rate has fallen to 4.2 percent—the lowest rate recorded since the mid-1970s. The number of unfilled job vacancies has hit a new high, with one vacant job for every 1.7 unemployed people, down from a ratio of 2.3 just two years ago. Pay growth has picked up to 2.8 per cent, which compares to an average rate of wage increases of 1.8 percent since the recovery started in mid-2009.

Another positive ingredient in the current economic picture is the growth of the world economy. We are in the strongest sustained phase of world economic growth since the financial crisis. The IMF is forecasting increases in global GDP of nearly 4 per cent both this year and next. All the three main regional engines of the world economy—North America, Europe and Asia—are growing well and providing a healthy backdrop for UK export growth. A very good barometer of global economic activity is air travel. The latest figures from the International Air Traffic Association (IATA) show that passenger traffic worldwide is nearly 10 percent up on a year ago, close to double the longer-term average rate of increase.

A negative factor in the short-term economic mix is the potential impact of Brexit uncertainty, which has undoubtedly held back UK growth in the past couple of years and pushed us to the bottom of the G7 growth league. Governor Mark Carney mentioned this issue explicitly a few weeks ago as a reason why the MPC might postpone a May rate rise which the markets had been expecting. But Brexit uncertainty has been with us in various forms for over two years now. It is not obviously a bigger factor now than a few months ago when MPC members were hinting strongly that a May rate rise would be on the cards.

There is never a perfect time to raise interest rates, but the job of the MPC is to take difficult decisions when required. The Committee has already passed up a number of good opportunities to start the process of returning to a more normal monetary policy—nearly a full decade on from the darkest days of the global financial crisis. Probably the biggest missed opportunity was in 2014 and 2015, when the UK economy was growing strongly and unemployment was falling sharply. At the end of 2015, the Federal Reserve started raising its key lending rate and has continued to edge US interest rates up since.

If the MPC waits until all the economic indicators are flashing amber or red in terms of inflationary risks, it will no longer have the luxury of making a gradual and slow increase in interest rates. When monetary policy gets “behind the curve,” rapid interest rate rises are generally required. This point has been grasped by the Fed across the Atlantic. It now needs to be reflected in the thinking and strategy of the Bank of England MPC.

This month’s interest rate decision is therefore a key test for the MPC. The Committee cannot continue to pursue the “manyana” strategy—of putting off until tomorrow what should really have been done yesterday. That is not in the best long-term interests of the UK economy.

A healthy economy requires positive real interest rates—an interest rate that at least matches the rate of inflation. That implies moving UK interest rates up to 2 per cent or more, as the US Federal Reserve appears set on doing. Interestingly, the US economy has not suffered from the Fed’s policy of gradually raising interest rates. In fact, US GDP in Q1 was nearly 3 per cent up on a year ago compared to an equivalent growth rate of 1.2 per cent here in the UK.

As we move into the tenth year of economic recovery this summer, the Bank of England MPC needs a clear strategy for raising interest rates, and stick to it even if there are short-term fluctuations in economic data. A May rate rise would be a clear signal that the Monetary Policy Committee has grasped the need to embark on a policy of gradual interest rate increases. Putting off the decision once again would further undermine the credibility of the Bank’s approach to monetary policy, and add to the uncertainties surrounding the outlook for the UK economy.