Why we must raise interest rates

 

Is it time for the Bank of England to take action? © Keith Braithwaite

Attention has turned to just how far and how fast interest rates will rise in Britain, and what the impact on the UK economy will be.

The Monetary Policy Committee of the Bank of England responded to the financial crisis and deep and prolonged recession by sharply reducing the bank’s interest rate to a historically low 0.5 per cent, and by buying £375bn of assets from the non-bank private sector, in a process known as quantitative easing. The aim was to reduce long-term interest rates, boost the money supply and support asset prices. This dramatically loosened monetary stance was fully in place by July 2012.

Earnings, when adjusted for inflation, are falling, so it will not feel like a recovery to many people—but the UK’s economic output has now surpassed its 2008 pre-recession peak, marking the end of an unusually long slump in output. The economy is expanding at a brisk pace, business investment is growing, and momentum and confidence are building, particularly in the southeast, and in the service sector. Forecasts are for growth of more than 3 per cent this year—the fastest among the world’s advanced economies—and close to the same rate next year.

As the economy returns to normal, this “exceptional monetary stimulus,” as the MPC itself has described it, is no longer appropriate. There is probably still a fair amount of slack in the economy—output per head remains well below pre-recession levels—and there is little sign of inflation. But the MPC should start raising rates from abnormally low levels long before spare capacity is completely eroded, not least because rate rises will have to start gradually.

There is considerable uncertainty about the economic impact of an increase after a sustained period of unusually low rates, particularly its effect on highly indebted households. It is not clear how the commercial rates faced by savers and borrowers will respond. By the time the economy is running at full capacity and inflation is threatening, it will be too late to start a process that may have to proceed very slowly, calibrating the effects of higher rates as it goes. The purpose of a gradual tightening of monetary policy starting now would be to slow the economy gradually, not to stop it in its tracks.

Abnormally low interest rates are creating the wrong incentives to spend and borrow, when households still need to improve their financial position. They risk building up problems for the future. Moreover, the banking system has enjoyed a long period of easy access to low-cost funding to allow its balance sheet to repair. It is time to stop the spoon-feeding and reduce its dependency.

Financial markets have already anticipated higher interest rates. Once the bank starts to raise the interest rate, the MPC has said it will review its quantitative easing programme. It has already stopped adding to it. Allowing the programme to decline gently over time would effectively tighten policy and relieve some upward pressure on the bank rate.

The MPC has indicated that the bank rate—which it sets—will rise gradually, and then only to a level well below its historic average. Before the financial crisis, it tended to be around 5 per cent. Mark Carney, the Governor of the Bank of England, has suggested the new normal might be closer to 2.5 per cent. There are good reasons for this in the short term. The difference between the interest rate set by the Bank and interest rates offered on the high street has widened considerably since the crisis began, suggesting the Bank’s rate may need to be significantly lower to achieve the same commercial interest rates and economic impact.

However, as Simon Ward of Henderson Global Investors has noted, that spread is now easing back. Moreover, there is little reason to believe the neutral equilibrium rate will be permanently depressed. In June, departing Deputy Governor Charlie Bean said that a rise in the bank rate to 5 per cent is conceivable in around 10 years—well within the lifetime of a mortgage.

One thing that should not be a prime factor in the decision on interest rates is that British and media obsession: house prices. Of course, housing and house prices matter hugely; any government with a social conscience would want to ensure its population is adequately housed. There are legitimate grounds for involvement: in the demand for and supply of housing; in land policy; regional policy; consumer protection; and financial education. But house prices are not primarily a matter for monetary policy, which should be concerned with the economy as a whole rather than one price. To target house prices could lead to considerable and unwarranted loss and volatility of output, income and employment.

House prices in any case may be slowing on the back of the Mortgage Market Review, the Bank of England’s new capabilities and, possibly, demand and supply factors such as a tendency for more people to live together. If a modest rise in the bank rate towards the new normal were to have a significant effect on the housing market, far from a reason for not acting, it would be evidence of imprudent mortgage lending and unsustainable house prices.

UK monetary policy is on an extraordinarily loose, emergency setting. The MPC should start to tighten now, in response to faster growth and a return to more normal economic conditions. To do so well before next year’s general election would also avoid any suspicion that politics may be influencing policy. Rates may have to be moved in small steps; the MPC should get a move on.