Sunday, February 08, 2004
Rates on the rise as the Bank shifts towards neutral
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

When the Bank of England was granted independence days after Labour’s landslide victory in May 1997, in what was arguably this government’s most significant policy move, we all seized on the new creature with enthusiasm.

The Bank, blinking in the bright sunlight for the first time, merited the closest scrutiny. The new monetary policy committee (MPC) consisted of real people, even if we insisted on characterising them as “hawks” and “doves”. In those heady days some readers accused me of writing too much and too often about the MPC.

Now things have settled down. The relationship between the MPC and those who write about it has become more like a marriage than the initial heady romance. The Bank has also settled down and perhaps got better at what it does.

In its first 4 years of independence it gave us an average of five interest-rate changes a year. In 2002 and 2003 combined, the MPC had a chance to change rates on 24 occasions but did so only three times.

Thursday, however, gave us another rate rise, from 3.75% to 4%, admittedly one that surprised few people. Plenty has already been written about it in the past couple of days but there remain a number of important questions.

The first and most important is: why did they do it? Just because something was widely expected does not mean it is right. The Bank’s job is to target inflation at 2% on the new consumer-price-index measure. Inflation on that measure is running at just 1.3% and, while this week’s inflation report will no doubt show that it is rising, it will be hard to argue that a genuine inflation problem is looming.

Not only that, but central banks normally like to hunt in packs and the Bank is looking something of a lone wolf. The European Central Bank is under pressure to cut rates from 2%. The Bank of Canada and Norway’s Norges Bank both cut their key interest rates last month. America’s Federal Reserve (interest rate 1%) and the Bank of Japan (zero) are in no hurry to push rates higher. Only Australia, which raised rates twice at the end of last year, is keeping us company. Sterling has been perky against the dollar, a factor that not only hits exporters but should serve to keep inflation down.

So why here? The Bank’s own statement cited several reasons: “The world economic recovery has become more broadly based. In the United Kingdom, output growth in the second half of last year was above trend and business surveys point to a further pick-up in the first quarter. Household spending and borrowing have been resilient, and the housing market remains strong.”

Cutting through all this, there are two simple reasons implied in the statement. The first, as noted here before, was that the Bank has had interest rates at an “emergency” low level because of the weakness of the world economy. That weakness is at an end, so the Bank is returning things to normal.

Why aren’t the central banks doing the same? The Bank’s approach is based largely on the so-called output gap — the amount of spare capacity in the economy. If we had suffered a recession in the past three years, like most other industrial countries, the output gap would have widened significantly, giving the Bank a lot of leeway before it needed to raise rates.

There was slow growth, but no recession, so the output gap is small and got smaller in the second half of last year when the economy grew at an above-trend annualised rate of 3.5%. As one who normally coos with the doves, I’d have voted for a hike last week.

How far will rates rise? Although everybody else is now doing the same, I still think that a good way of looking at this is in terms of the normal or “neutral” rate of interest. What would rates be if growth were on track and inflation running at the new target of 2%?

The answer is in the 4.5% to 5% range, which allows for a “real” (above-inflation) interest rate of 2.5% or 3%. Another way of thinking of the neutral rate is by taking the long-run growth rate, 2.5% or 2.75%, and adding the inflation rate to it.

As I say, that’s a useful way of thinking about where the Bank is heading by the end of the year, if things go according to plan. MPC members insist they take each meeting as it comes, and have no such strategy. But somewhere in the back of their minds they undoubtedly do.

There is, however, many a slip ’twixt cup and lip. Paul Tucker, the Bank’s executive director responsible for markets (and an MPC member) said last month there had been several occasions in its seven years of independence when the committee appeared to have embarked on a strategy of returning rates to neutral, only for “events” to intervene.

It happened in the autumn of 1998, when the crises affecting Russia and Long Term Capital Management forced the MPC, which had been raising rates, into an abrupt about-turn. It happened dramatically after the attacks of September 11, 2001 — the only time the independent Bank has cut rates outside a scheduled meeting.

What could happen to prevent a move to neutral? Terrorism again, or a collapse in the dollar and/or global stock markets. Inflation, which the Bank will say this week is heading towards its 2% target, could be surprisingly on the low side. America’s economy could hit the buffers, dragging down the global economy.

What could take us above neutral? A few more months of house prices rising more than 2%, as the Halifax reported for January, or even stronger GDP growth, sustained in 2004, than in the second half of 2003.

My best guess is that we will go to 4.75% by the end of the year but there are risks on either side. As things stand, the risks of rates rising by less are somewhat greater than an overshoot. I’ll keep you posted.

PS: A few years ago I wrote a pamphlet suggesting job insecurity was a myth and not supported by the evidence. It promoted an angry response. Some readers, obviously a bit insecure, threatened physical violence — one reason I had to take steps to ensure I look nothing like the picture that adorns this column.

An echo of that response comes as a result of my suggestion last week that exporting jobs to India was good for us. The arguments were that such job transfers would prevent labour shortages, raise productivity by allowing workers here to move into higher-value jobs, and benefit consumers and investors. The response was that I must be mad, misguided or, worse, a “typical economist”.

They are not alone. John Kerry, the Democrat front runner to challenge George Bush in November’s presidential election, has been wowing them on the stump with his pledge to stop the shift of US jobs overseas. He would, he says, “shut down every loophole, every incentive, every reward that goes to some Benedict Arnold CEO or company that take the jobs overseas and stick Americans with the bill”. Arnold, of course, was one of America’s most famous traitors, who conspired to hand over West Point to the British.

It remains a live issue here. Last week it was announced that half of all telephone-rail inquiries would be answered from Bangalore or Bombay. And a good thing, too. The people who did the job can move onwards and upwards while rail customers will get a cheaper and probably better service.

It is a simple choice. Exporting jobs is trade in a wider sense. Protectionism is harmful. Just as we would be economic losers by trying to restrict trade, so it is for jobs. Some people will never be convinced but this really is a win-win situation.

From The Sunday Times, February 8 2004

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