Sunday, November 05, 2023
Higher rates are working - but beware the risks of overkill
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. Not to be reproduced without permission.

It has been hard to ignore the actions of central banks, even after a week in which the Bank of England and America’s Federal Reserve e merely held interest rate steady. In time, central banks will receive less attention than they have over the past couple of years, when they have been rushing to catch up with runaway inflation.

We should soon be entering a period in which the main question about the central bank mantra of “higher for longer” will be how much longer? When you have reached peak interest rates, the issue is when they will come down again and that should be the case at some stage next year, if not for a few months.

In the meantime, not far from where I am writing this, there is a living example of a textbook monetary policy experiment at work. I am not talking here about our own dear Bank of England, which is still troubled by aspects of inflationary pressure. Three members of the Bank’s monetary policy committee (MPC) voted to raise Bank rate from 5.25 to 5.5 per cent on Thursday, though they were outvoted by the six who opted to hold. In what was described by analysts as “a hawkish hold”, Andrew Bailey the governor, reiterated that the Bank “will be watching closely” to see whether further hikes are needed.

No, my attention was grabbed by developments a little further away, across the Channel. Figures published a few days ago by Eurostat, the EU’s statistical agency, showed two things. One was that eurozone inflation is dropping sharply, and on its preferred measure fell to just 2.9 per cent last month, from 4.3 per cent in September.

The other was that this has been achieved by snuffing out growth. Gross domestic product in the eurozone fell by 0.1 per cent in the third quarter and rose by 0.1 per cent in the EU as a whole. In both cases, GDP was up by a tiny 0.1 per cent on a year earlier, implying an absence of growth. You can debate whether this was achieved by tighter monetary policy – higher interest rates – alone, but this is exactly what central banks would be looking for if they are seeking to drive inflation out of the economy, significant weakness in demand.

As always, there were big variations in the performance of eurozone economies, and the quarterly eurozone figures were dragged negative by another big fall in Ireland’s volatile GDP figures. Some economies are still showing good growth, including Spain, Portugal and Belgium. Some are showing negative annual inflation rates, including Belgium again, and the Netherlands.

Europe’s performance contrasts with America, where the Federal Reserve held rates, despite an acceleration in GDP growth to an annualised 4.9 per cent in the third quarter, its best for nearly two years, and where analysts cannot be sure that the job is done.

It also contrasts with the UK, where the Bank appears to have done better with the snuffing out growth part, predicting the economy to be “broadly flat” for the next few quarters, than the inflation bit. It does not expect to drop below 3 per cent until early 2025.

A flat economy, with zero growth predicted next year (election year), with the risk that it could be worse, means the issue of whether the Bank of England has overtightened – raised interest rates too much – has become a live one. I used to feature the Institute of Economic Affairs’ (IEA) shadow MPC a lot in these pages, and indeed was instrumental in getting it to announce a “decision” ahead of each actual MPC meeting, but we lost touch.

The latest recommendation from the IEA committee was very interesting. It called on the Bank to cut rates by a quarter of a point to 5 per cent on Thursday, and to scale back its “quantitative tightening”, the reversal of the earlier policy of quantitative easing. It is worried by the downturn in M4 money supply growth, broad money, which has turned significantly negative.

“There is mounting evidence that the UK’s monetary policy is too tight and could lead to price deflation in a few years and potential recession in the interim,” said Trevor Williams, who chairs the IEA committee. “The Bank of England should act now by lowering interest rates.”

There was never any serious possibility of that happening on Thursday, not least because the money supply does not feature prominently, if at all, in the actual MPC’s decisions. It was also too soon for a majority on the MPC to contemplate a cut in rates after running them up so aggressively until September.

This will, however, become very relevant in coming months. We will know more about what is happening to the UK economy, despite uncertainty over the data, this week. Friday will bring monthly GDP figures for September and the first release of GDP data for the third quarter as a whole.

The context is that monthly GDP rose by 0.2 per cent in August after a fall of 0.6 per cent in July. If the previously published figures are unrevised, this means that September must show a rise of 0.4 per cent or more for GDP not to have fallen in the third quarter. The Bank thinks third quarter GDP will have been flat.

If it were to show a small fall this would not be a massive moment – quarterly GDP dropped slightly in July-September last year – though the Queen’s death and funeral was a factor in that. A weak third quarter would, however, encourage the view that UK monetary policy is hurting, with many sectors of the economy now in retreat.

It would also add to confidence that it is working, and not before time. The Bank, and its central bank counterparts, however, must be sure that it is not working too well. A flatlining economy is one thing, a proper recession quite another.

A former MPC member I was talking to the other day described well the problem the Bank would face if overtightening led to recession. It would be caught on the other wise of the problem it has faced up to now, which is that the lags between its actions and their impact have got longer.

That is true when it comes to raising rates, because so many people are now on fixed-rate borrowing, but it would also be true for rate cuts. Rate cuts used to offer a speedy stimulus to the economy, heading off recession or lifting it out of it. It is harder now. Despite its hawkish tone, the Bank has a vested interest in avoiding too much pain.