Sunday, September 19, 2010
The case for higher rates
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk. This is an excerpt.

Bank rate, reduced to a 315-year low of 0.5% as part of the authorities’ desperate bid to prevent economic and banking collapse, has now been at that level for 20 months.

There is no sign of any shift in that position. Though we will not know for sure until the minutes are published this week, the Bank of England’s monetary policy committee (MPC) is highly likely to have voted 8-1 for no change in rates, with Andrew Sentance as the only dissenter.

Mervyn King, speaking at the Trades Union Congress in Liverpool, not an easy gig, told unions the Bank could provide a further monetary stimulus (through quantitative easing not trimming Bank rate further) if “storms” facing the economy are serious enough. Martin Weale, the MPC’s newest member, concurred in evidence to the Commons Treasury committee.

Sentance has been a lone voice since June, when he first voted to hike rates, though he has support on the Institute of Economic Affairs’ shadow MPC.

Though this newspaper carried his June piece explaining why he was moving in favour of higher rates, I have tended to side with the MPC majority, because the recovery needed all the help it could get. The loosest monetary policy was needed to compensate for the big fiscal tightening (tax hikes and spending cuts) ahead.

There is still a lot in that but lone voices can sometimes be right. Sentance’s argument has four strands. Firstly, you do not maintain emergency settings once the emergency is over. There is a time to turn off the flashing blue light.

Secondly, the recovery has been stronger than most people realise. World industrial production is rising at its fastest rate since before the dot.com bubble burst, more than 10% in the past year, and has exceeded its pre-crisis levels. In Britain, manufacturing output has risen over the past year at its fastest rate since 1994.

Thirdly, there may not be as much spare capacity in the economy as thought. The latest stunning labour market figures, showing a 286,000 rise in employment in the May-July period, the biggest since records began in 1971, were overshadowed by a tiny rise in the claimant count. The job market, which performed well in the recession, is starting to tighten.

Fourthly, the longer rates stay so low, the harder it is to shift them. If the Bank had made clear 0.5% was very temporary, everybody would have been prepared for the exit strategy. The risk is that the Bank leaves it too long, having given the impression ultra-low rates are permanent, any decision to hike could look like panic.

These are good points. The case for higher interest rates is not, incidentally, based solely or mainly on the current inflation figures. The latest numbers were a touch disappointing, showing consumer price inflation stuck at 3.1% and retail price inflation only down from 4.8% to 4.7%.

The air is thick with warnings from clothing retailers about higher wage costs and the rising price of cotton, which they say could push up prices by between 5% and 8%. Significantly higher food price inflation is also in prospect, it seems, while George Osborne’s Vat hike to 20% will come through in early January.

Even after a big rise in August (which followed an even bigger fall in July) clothing prices are 1.7% lower than a year earlier. More generally, as after previous recessions, spare capacity and intense competition should bear down on prices. The prospect remains for inflation to wend its way down to the 2% target or below. Is this not game, set and match to those wanting to keep Bank rate low? Not quite.

As spare capacity left by the recession is used up, inflationary pressures will increase. The post-recession drop in inflation below 2%, which the Bank expects in late 2011 or early 2012, could be fleeting.

Given that inflation has been above the 2% target for more than three-quarters of months since mid-2005, it will need more than a fleeting drop below it to ensure the Bank retains its credibility. Its own inflation expectations survey, carried out by NOP, shows that people expect 3.4% inflation over the next 12 months.

What about the strongest argument in favour of maintaining a 0.5% Bank rate, that the recovery needs it? The Bank would not want to be blamed for tipping the economy back into recession.

It is a very good argument for doing nothing, but we have to think also about what a 0.5% Bank rate is achieving. It is doing a lot for the banks, which have increased their margins. For households, the average standard variable mortgage rate is 3.92%, the average credit card rate 16.7%, and the average overdraft rate 19.1%.

Small businesses face average rates on new loans (up to £1m) of 3.3%, though for many of them - as for households - the issue is as much the availability of credit as its price. Savers, meanwhile, are suffering. The average interest rate on a cash Isa is 0.6%. At some stage savers will have to be rewarded far better than now, which will be part of the rebalancing of the economy.

I am not suggesting the Bank needs to raise rates next month, or even in November. To do so on the eve of or immediately after the spending review on October 20 would smack of sadism.

But the Bank does need to prepare the ground. King’s public stance, that another monetary stimulus via quantitative easing is as likely as a shift towards higher interest rates, is a bit too even-handed.

More easing would only be justified if there was a second wave of the crisis. The further we move away from the emergency, the more the argument will build for normalising interest rates. That does not mean a speedy return to a 5% Bank rate. It does mean getting ready for a controlled move from the current near-zero rate.