Sunday, August 05, 2018
A curiously downbeat rate rise. Is it going to hurt?
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.

Lord Keynes once memorably hoped that economists should be thought of as “humble and competent” people like dentists, a statement that students of the great man have been debating the meaning of ever since.

But if, as is likely, he meant that economists should be thought of as technocrats, quietly going about their business, Thursday’s interest rate rise was very much like a visit to the dentist. I don’t mean that it was particularly painful but there was no fanfare to mark the moment when Bank rate moved above the emergency 0.5% level it has occupied for almost the past 10 years.

There were no dancing girls, or boys. No banners outside the Bank. Mark Carney, the Bank governor, is not given to rhetorical flourishes, or the carefully-honed sporting analogies favoured by his predecessor, but his determinedly technocratic explanation of why the official interest rate had been raised to 0.75% ensured that nobody got too excited. Given that the markets had fully priced-in the announcement by the time it occurred, perhaps excitement was too tall an order.

It was, nonetheless, an important moment, and it was important – and perhaps the only surprise – that the decision was unanimous. A split vote on the nine-member monetary policy committee (MPC) had been expected. I have argued before that when the Bank broke out of the long period of ultra-low rates it was important that every member of the MPC was signed up to it.

That was not so in November, when the Bank reversed the emergency Brexit rate cut, and hiked from 0.25% to 0.5%. It was this time, and that is a good thing.

Was this unanimity reflected in the strength of the case the Bank made for raising rates? In my time following these things, I have witnessed approaching 70 increases in UK interest rates. The past 10 years have thus been unusually fallow.

Most rate rises have fallen into two categories. Traditionally, the reason for raising rates was to stem a slide in the pound. Either the markets transmitted to the authorities that policy was too loose by selling the pound, or action simply had to be taken to stop a sterling rout and its subsequent inflationary effects.

That was the traditional reason. Since Bank independence in 1997, however, it is hard to recall a single example of a sterling-driven rate hike. The other reason for raising rates, which at times has been screamingly obvious, is to slow an over-exuberant and thus inflationary economy. At the end of the 1990s, when the Bank took charge and the economy grew by more than 3% a year for four years in a row, it was not hard to argue for rate rises.

Times have changed. Though sterling has been soggy, and remained so after the rate rise, it was not the culprit. Similarly, nobody would say that, other than the passage of a very long time with interest rates at emergency low levels, it was screamingly obvious that they had to go up now.

One of the other traditions about rate rises is that they are not generally welcomed by business organisations. Sure enough, the British Chambers of Commerce described Thursday’s hike as “ill-judged” while the Institute of Directors accused the MPC of having “jumped the gun”. Did they have a point?

On the face of it, the Bank had a clear enough case for raising rates, even though business conditions are at best mixed. As Carney put it: “Employment is at a record high, there is very limited spare capacity, real wages are picking up and external price pressures are declining. With domestically generated inflation building and the prospect of excess demand emerging, a modest tightening of monetary policy is now appropriate.”

It was, however, a marginal call. At one time the Bank was looking for stronger growth in wages than current sub-3% rates before raising rates. Now it can call on the combination of a slight acceleration in wages and continued weak productivity to point to the danger of rising unit labour costs. These are now expected to grow by more than 2% annually in coming years, from only 0.5% a year in 2010-15, the Bank’s inflation report notes.

Another Bank key judgment, that “demand growth outstrips potential supply growth, and a margin of excess demand emerges, pushing up domestic cost growth”, is also very much at the margins. The Bank thinks the economy will average 1.75% growth in 2019 and 2020, after 1.4% this year, so pulling just ahead of the economy’s 1.5% a year speed limit. But growth has only to slip a little below the Bank’s predictions and the danger passes.

The case for raising rates was certainly technocratic. The best policy moves are those that are easiest to explain, and the Bank would struggle to explain this one, in layman’s language to the regulars at the Dog and Duck. In comparison with their colleagues at America’s Federal Reserve, MPC members have a tougher task.

That may be the nature of the game now, one which operates on small margins. As foreshadowed last week, the Bank also produced something new in the form of R* (r-star), its estimate of the equilibrium interest rate. I have to say that, as a tool or signal, it has some way to go before it is very useful.

It could be that, under certain conditions, R* is between 0 and 1%, compared with between 2.25% and 3.25% before the crisis. That would convert, using the 2% inflation target, into an actual or nominal interest rate of 2% to 3%, compared with its old level of 5%. But to get even to 2% to 3%, the economy has to shrug off some of the current weakness in productivity and growth and the markets think that will take until well into the 2020s.

For that and other reasons, it seems sensible not to expect the Bank’s promise of “limited and gradual” rate rises to turn into a rush. One of the big dangers of ending a long period of ultra-low rates was that people, businesses and the markets would interpret any move as the first of many and that the Bank would get “behind the curve” and be forced to tighten in a rush.

The Bank has avoided that. Sterling fell on the hike, because of the expectation that it will be a long wait until the next one. With Brexit looming, assuming it is not messy enough to require rate cuts, it is touch and go whether the next hike will come before Carney’s departure as governor in mid-2019. By that time, another visit to the dentist will not be anything to get too concerned about. It could even be overdue.