Sunday, September 17, 2017
The Bank can't afford to cry wolf on rates again
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

A Rip Van Winkle who went to sleep 20 years ago and woke up around midday last Thursday, when the Bank of England made its latest interest rate announcement, would be more than a little bemused. The level of official interest rates – 0.25% - the lowest in the Bank’s history would be a source of amazement; 20 years ago the rate was 7%.

So, and only slightly less so, would be the excitement generated by the Bank’s broad hints that at some stage in the coming months interest rates might rise from this extremely low level. Veterans of monetary policy remember the days when rates went up, without warning, by large amounts.

Even leaving aside special episodes like Black Wednesday in September 1992, discussed here last week, I can remember months like January 1985, when we saw two rate rises of two percentage points each, within the space of a couple of weeks.

That was in response to a very weak pound. Our very weak pound now got a boost from the more hawkish talk from the Bank on Thursday and, in particular, the phrase in its minutes that “a majority of MPC (monetary policy committee) members” think that if the economy continues on its current path “some withdrawal of monetary stimulus is likely to be appropriate over the coming months”.

It was given a further boost on Friday from hawkish comments by the MPC member Gertjan Vlieghe, previously thought to be the committee's arch dove.

Some withdrawal of monetary stimulus, to translate from Bankspeak, means in the first instance a rise in interest rates, and it has been a long time since that happened; more than 10 years.

Nor should this “hawkish” message been much of a surprise. It was implied by the Bank’s inflation report last month. It has been given added urgency by the jump in inflation to 2.9% last month, with Bank economists expecting it to exceed 3% in October.

The strength of the labour market, with the employment rate hitting a record high of 75.3% in May-July and the unemployment rate dropping to 4.3%, its lowest since 1975, has pushed the economy closer to capacity.

There are three other things to know about the Bank’s approach, and its “hawkish” hints of a rate rise on the short-term horizon. The first is that while it was prepared to used monetary policy – last August’s rate cut to 0.25%, the extension of quantitative easing and the launch of the term funding scheme to cushion the shock of the Brexit vote, it cannot prevent the long-term damage from Brexit.

As it put it on Thursday: “Monetary policy cannot prevent either the necessary real adjustment as the United Kingdom moves towards its new international trading arrangements or the weaker real income growth that is likely to accompany that adjustment over the next few years.” So, while a renewed downward lurch for the economy as a result pf Brexit uncertainty would change its plans, it cannot be expected to leave rates on hold for the years it will take for the Brexit dust to have settled.

The second important factor is that it does not take much growth these days before the economy bumps up against the Bank’s speed limits. Brexit and other factors have damaged the economy’s supply-side, to that potential or “trend” growth is only about 1.5% a year. Growth of 0.25% a quarter, the average for the first half of the year, is below that potential but only a small rise would take it above it. The economy, in other words, does not have to be racing away to justify higher interest rates.

The third point related to wages, a key factor. After Wednesday’s official figures showed average earnings growth at just 2,1%, weaker than expected, some in the markets decided that rate hikes were off the agenda. They were mistaken.

The Bank thinks that the underlying growth in pay is stronger than the figures suggest. Official statisticians point to so-called “compositional” effects in the job market; the mix of skills, sectors (some pay a lot less than others) and occupations. Adjusting for changes in these, Bank staff think the underlying growth in pay is nearer to 3% than 2%; these effects depressing earnings growth by 0.7 percentage points.

Bank economists have also gradually discovered, in their quest to find the “equilibrium” rate of unemployment – below which wages start to accelerate – that something fundamental has changed. The search for that equilibrium goes back some years. When Mark Carney became governor in the summer of 2013 and famously launched his forward guidance on interest rates, it was to say that the MPC would not consider a rate hike until the unemployment rate dropped below 7%. It did, quite quickly, but the Bank gave scant consideration to hiking rates.

Then estimates of the equilibrium rate dropped to 5%, then 4.5%. Now, even with an unemployment rate of 4.3%, wages are not accelerating. Why isn’t falling unemployment pushing up wages at a faster rate? The answer, which is implicit in the Bank’s unemployment analysis, is the crucial new factor is productivity.

If productivity is weak, as it is, employers will not give bigger pay rises even in a tight labour market. They have to be justified by higher productivity; output per worker. Looking for the inflationary impulse from wages could be the modern equivalent of Goodhart’s law, invented by the economist and former MPC member Charles Goodhart. This, which emerged during the 1980s’ monetarist era, was that any measure targeted by the authorities automatically became distorted. The same may now apply to wages.

So what happens now, and what should happen? Mention of forward guidance is a reminder that we have been sold a pup by the Bank on interest rate warnings before. The governor followed his 2013 guidance with a mid-2014 warning that rates could rise sooner rather than later. A year later, in July 2015, Carney travelled up to Lincoln Cathedral to deliver a speech warning that a decision on rates would move “into sharper focus” at the end of the year. Though in the run-up to June 2016 the Bank did not warn explicitly of rate hike in response to the weaker pound that would follow a Brexit vote, merely saying it would present a trade-off, others including the then chancellor did.

That is why the latest warning is being taken by some with a pinch of salt. Thrice-bitten, twice-shy is not a proverb but in this context it probably should be.
It is why, for the sake of its own credibility, the Bank has to follow through this time. Of course things can change, and that would be understood. The initial move on rates would be to reverse last summer’s emergency rate cut and then stake stock before embarking of further modest and gradual rises.

But doing nothing after another signal that higher rates are on the way would be a mistake. The Bank cannot afford to cry wolf again.