Almost all the commentary ahead of the Bank of England’s monetary policy meeting at the end of the month has focused on whether interest rates should be cut, or left on hold. In contrast, I would be itching to vote for a hike.
There does at least appear to be an emerging consensus that the Bank should not pay too much attention to the weak economic data reported in the final quarter of 2019. These figures were overshadowed by political uncertainty and the survey evidence since the decisive election result has already markedly improved. (See, for example, the latest CBI survey of manufacturers, the Deloitte CFO survey, and the flash estimate of the composite PMI for January.) We also now know that the labour market has remained strong, with employment rising by more than 200,000 in the three months to November.
But I would go further. For a start, with interest rates already so low, you have to ask what the point would be in cutting them any more. Admittedly, at 0.75% the Bank’s policy rate is higher than when it was last cut, from 0.5% to 0.25%, in the wake of the shock of the vote to leave the EU in 2016. That small move, alongside additional quantitative easing, helped to restore confidence.
Nonetheless, this time it really is different. In 2016 the survey evidence (such as the PMIs) was signalling an imminent recession and, even more importantly, there had been some doubt about how policymakers would respond. After all, ahead of the referendum Osborne’s Project Fear had warned of a punishment Budget and higher interest rates if the public dared to vote to leave. The Bank’s policy easing was therefore especially reassuring.
Rolling forward to today, the survey evidence itself is providing the reassurance. Rather than providing a further boost, a rate cut now might be seen as a vote of ‘no confidence’ in the economy and especially on the impact of Brexit, given the proximity to the UK’s departure from the EU.
I am also sceptical of the case for an ‘insurance cut’ just in case the survey evidence is wrong and the economy deteriorates further. Rate-setters should act on the basis of what they think is likely to happen, not tail risks. And do we really want the Bank to signal that it will always bail out the economy with additional policy easing, come what may, despite all the ‘moral hazard’ that would bring?
Sentiment aside, it’s worth asking how a rate cut would help to fix any of the underlying problems in the UK economy. In particular, productivity has stagnated despite a decade of ultra-low interest rates and perhaps even partly because of them. Cheap credit has supported ‘zombie’ firms that really should have been allowed to fail – a problem well known in Japan but also observed in many other countries. What’s more, companies have had to divert large sums into pension schemes as falling discount rates have increased the present value of their long-term liabilities.
Very low interest rates also contribute to financial imbalances in other ways. Households are encouraged to run up larger debts than they would otherwise have done. Asset prices become ever more stretched. While this might support spending and economic growth in the short term, it is storing up bigger problems for the future.
I am also concerned about ‘mission creep’. The Bank’s main job is (or should be) to deliver monetary and financial stability, not to manage short-term fluctuations in the real economy. It is true that headline CPI inflation, at 1.3% in December, has fallen further below its 2.0% target, but this is not a large gap, even by recent standards. Crucially, there is little or nothing in the forward-looking indicators to suggest that inflation will not return towards 2.0% soon. In particular, broad money growth is low but accelerating again, inflation expectations are firm, and the economy is close to full employment.
‘Mission creep’ also appears to be distorting the boundaries between fiscal and monetary policy. There is now a broad consensus in favour of looser fiscal policy (‘ending austerity’), reflected in the government’s new fiscal rules, and it is widely assumed that this is consistent with an extended period of low interest rates. Indeed, low interest rates may themselves strengthen the case for fiscal loosening, both because conventional monetary policy is less effective when interest rates are already close to zero, and because government borrowing is then cheaper.
There is clearly something in this. During a recession you would expect fiscal and monetary stimulus to complement each other. However, it is far from obvious that the economy needs a large fiscal stimulus right now to support demand. Instead, a further fiscal loosening in the March Budget might reduce the need to keep interest rates so low (just as the Trump boost in the US encouraged the Fed to raise interest rates there). At the very least, this is another reason for the Bank to wait and see.
Of course, the Bank might be relatively relaxed about an increase in infrastructure spending that raises productive potential and allows the economy to grow faster without creating additional inflation. But the problem of cheap credit leading to financial excesses applies just as much to the government too as it does in the private sector. Expectations that borrowing costs will remain low, come what may, could further undermine fiscal discipline and lead to an increase in the number of relatively uneconomic projects getting the green light. With less effective budget constraints, we could end up with more HS2s.
In short, the Bank should continue to focus on returning interest rates towards more normal, healthy and sustainable levels. Even if it would too much of a shock to raise rates this month, the next move should still be up, and the sooner the better.
This is an expanded version of a piece first published by CapX