There are strong arguments against raising UK interest rates as far as the markets are currently expecting. But I do not believe these arguments are sufficient to justify not raising rates at all…
This is an extended version of my submission to the Shadow Monetary Policy Committee run by CityAM, where I reluctantly voted for a quarter point increase in UK interest rates to 4%.
Vote: Raise 25 basis points
What has influenced your decision?
A small rate rise now would help to safeguard credibility and reduce the need for larger increases later. Crucially, an extended period of high inflation would be more damaging for output and for jobs in the coming years.
This is a finely balanced decision. There is still little evidence that higher energy prices are having major “second-round” effects, either on inflation expectations or on wage pressures. Broad money growth also remains below 5%, which is well below the pace that helped to fuel the surge in inflation in 2022.
These are indeed strong arguments against raising rates anywhere near as far as the markets are currently expecting – and the MPC should make that clear. But I do not believe these arguments are sufficient to justify not raising rates at all.
Here are four points in favour of an immediate hike…
1. Activity has proved unexpectedly resilient, including in July’s GDP data and August’s composite PMI. This lessens the risk that a pre-emptive rate rise would push the economy into an unnecessary recession.
2. The latest recruitment surveys suggest that the labour market is close to bottoming out, even though this has yet to be reflected in the official data.
3. Inflation expectations are likely to pick up again as the recent increases in global energy prices feed through to household bills and to prices at the pump.
4. Most importantly, inflation has been above 2% for most of the last five years and is unlikely to return to target for at least another year. Even excluding energy, inflation has consistently been above 2% since 2021.
The argument that policymakers need to look past “temporary shocks” is therefore wearing increasingly thin. A quarter point hike, to 4%, would still leave UK interest rates at historically low levels. But the Bank must do something to show that it is committed to bringing inflation back down.
To be clear, I am not suggesting that an increase in UK interest rates would have any impact on global energy markets. Instead, the aim would be to prevent a temporary increase in inflation from becoming baked in to the economy.
Nor am I denying that the increase in price pressures reflects a supply shock rather than runaway demand. But if there is a shortfall in supply, for whatever reason, demand needs to be contained as well.
Finally, I see no compelling reason why the Bank of England should not follow the European Central Bank, which raised rates in the euro area last week for the second time this year. Indeed, the commentary justifying the ECB’s decision made several points which could equally apply here:
- “The Middle East conflict keeps driving up prices” (UK ✅)
- “Inflation is likely to be above our 2% target for quite a while” (UK ✅)
- “The risks to the inflation outlook are to the upside” (UK ✅)
- “The economy is holding up better than expected” (UK ✅)
The other decision…
The MPC must also decide how quickly the Bank should reduce its holdings of government bonds. The markets expect the annual pace to slow from £70 billion to £50 billion.
There is a case for going further to reduce the upward pressure on gilt yields. One alternative would be to halt “active” sales and simply undertake £30 billion of “passive QT”, where maturing bonds are not replaced.
But the MPC will want to avoid the impression that it is trying to bail out the government. The key point is that bond prices have not become detached from fundamentals and markets are not “disorderly”.
Instead, investors are rightly worried about economic and fiscal policies, and the amount of bond issuance. Equally, the supply-side problems in the UK economy, especially in the labour and housing markets, cannot be solved by keeping interest rates down.
Governments need to address those concerns first, and central banks should leave them to it.
PS. in the event, CityAM’s Shadow MPC voted by 6-3 to keep UK interest rates on hold, which may well be the outcome on the real MPC too!
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Plain-speaking Economics 