Friday, July 16, 2010
The case against a rate hike
Posted by David Smith at 03:45 PM
Category: Thoughts and responses

The July minutes from the Bank of England's monetary policy committee should make interesting reading. We know there will be one vote for a hike, from Andrew Sentance. There are unlikely to be others but the tone of the minutes will be important. Sentance's view was set out in an entertaining speech, with a bit of a Led Zeppelin theme, available here.

The counter argument has been a little woolly, usually along the lines of the Bank being uncomfortable with above-target inflation but reasonably contfident - though not completely - that spare capacity will bring it down. A fuller argument was provided by David Miles, another MPC member, in a speech in Bristol.

Firstly, on why were rates reduced so much: "I believe it has been right to loosen aggressively the stance of monetary policy because of the scale of the deflationary and recessionary forces unleashed by the remarkably rapid downturn that followed the crisis in the banking sector. This crisis intensified dramatically in the autumn of 2008 when the banking system came close to total
collapse. That would have been an outcome comparable in its impact to the failure of the system for electricity supply."

As to why rates should stay low: "Since I joined the MPC just over a year ago I have not voted to increase interest rates – despite the fact that inflation has more often than not been above the target.

"But even though price rises over the past year have been running at relatively high levels, the underlying domestic inflationary pressures are not strong. Wage rises – despite a move up in household inflation expectations – remain low. Without a pick up in wage inflation I find it hard to think it at all likely that inflation being significantly above target is sustainable. Of course wage pressures may build significantly over the next year or so, though I do not believe this is the most likely outcome.

"And risks of an extended period of low growth – which would further weaken those pressures – are real. In talking about the possibility of an extended period of low, or no, growth I may sound blasé about inflation risks. But the point about risks is that more than one can exist. There are risks that inflation stays well above the target level; there are also risks that demand in the economy falls even more below supply capacity so that inflation further ahead drifts below the target.

"In considering how to balance these risks there is a need to look through short run and potentially transitory factors. Reacting to today’s inflation rate (which reflects where the level of prices is now relative to 12 months ago), rather than where inflation will be looking ahead, is not the right thing to do. The inflation rate can move a lot in a short period. Inflation was barely 1% less than a year ago."

Miles's speech is here.