Sunday, January 09, 2011
Financial fragility keeps interest rates low
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

fragile.bmp

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

It is early days but so far inflation is the economic story of the year. Some of this is specific to Britain. Tuesday’s Vat increase to 20%, though the extent to which it has been passed on is patchy, has got everybody thinking about higher prices. Rail fare increases averaging more than 6% and an average petrol price of almost 128p a litre (132p for diesel) represent the reality of those higher prices.

Some of it is global. Britain's high fuel prices reflect the chancellor’s desire for revenue, with both an excise duty and Vat effect. But they are also a consequence of a crude oil price which is threatening to rise above $100 a barrel again. Food prices are at an all-time high, according to the UN’s Food and Agriculture Organisation.

Central banks were put on earth to worry about inflation. Across the world, many have raised rates because of the inflationary threat. This is mainly in the emerging world, including India and China. Beijing hiked on Christmas Day.

Some advanced economies such as Sweden and Norway raised rates in 2010, as did Australia. The question is when we see a move from the big four, our own Bank of England, the Federal Reserve, the European Central Bank and the Bank of Japan.

The Bank of England’s monetary policy committee (MPC) has its first meeting of the year this week. There have been suggestions that a good way to show its anti-inflationary resolve would be to surprise markets by nudging Bank rate higher.

Andrew Sentance, so far the only MPC member to vote for a rate hike in the post-Lehman Brothers era, has fought a brave and increasingly public campaign to seek to convince people. Not only does the Bank need to show it means business on inflation but the beginning of the return of rates to normal levels would show the MPC was more confident about the economy.

I have quite a lot of sympathy with Sentance’s view. The longer Bank rate is held at 0.5%, and we are approaching the second anniversary, the harder it will be to shift from this extremely low emergency level.

Other central banks have raised rates without the skies falling in. Properly handled, there is no reason why a nudge up to 0.75% would be interpreted by the markets as a non-stop journey up to a “normal” 5% level. The effect of a gradual rise in Bank rate on interest rates in the economy as a whole may be limited. The banks have the scope, after all, to reduce their margins.

Why has most of the MPC been so reluctant to join Sentance in gradually raising Bank rate? It may reflect a reluctance to be the first of the big four to break ranks.

Most of it reflects what the MPC majority would see as hard economic arguments. Thus, the spare capacity left over by the recession will bear down on inflation over time. Inflation will move higher over the next few months; the markets are expecting 4%, with retail price inflation exceeding 5%. But the more that can be blamed on higher Vat, the more helpful it is to those against early rate hikes.

Not only will this month’s Vat hike drop out of the inflation calculation in a year but its ultimate effect, like any tax hike, is deflationary. The same is true of commodity prices. They are outside the Bank’s control and their effect will be to slow global growth, partly because some central banks have responded to them by hiking rates.

Inflation expectations are rising. The latest Citi-YouGov survey shows people expect inflation to average 3.5% over the next 12 months and 3.8% over the 10 years. But the MPC majority appears relaxed about this, at least until these higher inflation expectations are converted into faster pay rises, which is not yet happening.

There is another reason. The “shadow” MPC, which meets under the auspices of the Institute of Economic Affairs, is instinctively more hawkish than the actual MPC. But, after a couple of knife-edge 5-4 votes to hold rates at the end of last year, its latest vote to hold rates is a more comfortable 6-3.

Its majority is concerned about the continued weakness of money and credit growth, which brings us back to Friedman. As Gordon Pepper, the veteran monetarist economist, puts it: “Do not judge the stance of monetary policy by the behaviour of interest rates. It should be judged instead by in depth analysis of the behaviour of the monetary aggregates.” With the adjusted M4 money supply measure growing just 1.4% annually, a monetarist would see little inflationary danger.

Dovish shadow MPC members are also worried about the government’s fiscal measures (a January rate hike hard on the heels of the Vat increase would be a double whammy), weak growth in Britain’s European trading partners and de-leveraging - running down debt - in the banking system. The practical effect of this deleveraging is very weak bank lending growth, so far unresponsive to ultra low rates.

This is perhaps the nub of it. It is easy to forget that the Bank has two core purposes. One is monetary stability; meeting the inflation target. The other is financial stability, “protecting and enhancing the financial systems of the United Kingdom”.

In theory, the MPC should concentrate solely on monetary stability. It is hard to avoid the conclusion that since the onset of the banking crisis, much of its attention has been diverted to the second, financial stability objective. A normal monetary stability approach would see rates on their way up by now. The Bank clearly thinks things are a long way from normal.

At some stage the MPC will surprise us with a rate hike. Surprises, by their nature, cannot be anticipated, so it could happen at any time, including this week.
The Bank, however, has given us no indication it is contemplating such a move, now or in the near future. It needs to be confident about financial stability, in Britain and the wider world. The implication is that it does not yet have that confidence.