Winner of the New Statesman SPERI Prize in Political Economy 2016

Monday, 30 October 2017

A short guide to why we should not raise UK interest rates

Everyone expects the MPC to raise rates on Thursday. This would be a mistake. Discussion about interest rate changes in the press normally involve large amounts of data and charts about the state of the economy. Here I want to do the opposite: to present the minimum you need to know to understand that raising UK rates right now is the wrong thing to do.

Everyone should know that UK inflation is currently around 3% because of the Brexit depreciation. But because the impact of a deprecation on price inflation is temporary if wage inflation remains flat, the Bank said they would ignore this temporary rise. The key is to look at whether average earnings inflation is responding to higher consumer price inflation. The answer is they are not: average earnings growth has been slightly above 2% all this year, which is a little lower than the average for 2016.

But what about unemployment being at a 42 year low? Surely that means earnings growth is just waiting to kick off. The first point is that unemployment is not currently a good measure of labour market slack. A better measure is the Resolution Foundation’s underemployment index, which is still above levels before the global financial crisis. And before you say but that was a boom period, it wasn’t. UK core inflation was below 2% throughout, and earnings growth was consistent with this.

The other thing to say is that it is quite wrong to assume that we know what the level of labour market slack is that would lead to increases in earnings growth (what economists call the NAIRU). The NAIRU moves over time. As just one example of why it might move, a labour force that rents is likely to be more mobile than one that owns a house, and so the trend towards renting should reduce the NAIRU.

So looking at the labour market, there is no sign that we are close to a level where earnings inflation might pick up. And that is pretty well a precondition for inflation to exceed its target of 2% over the medium term. That is all you really need to know. If you want to know why the MPC probably will raise rates, read on.

What I suspect the Bank are worrying about is that Brexit has created what economists call a negative supply shock. In particular, both investment and productivity growth are much lower than the Bank were expecting before Brexit. They will point to various survey measures which show firms do not have any spare capacity. But this reasoning I think indicates a conceptual weakness.

Firms have two responses to lack of capacity: raising prices or investment. By choking off demand and raising rates when firms run out of capacity the Bank will discourage investment, and right now what the economy desperately needs is more investment and the productivity improvements that brings with it. The Bank shouldn’t worry about a bit of inflation that might come with higher investment, because 2% earnings growth is an anchor that will prevent inflation deviating from target for any length of time.

That should be enough, but there are two other reasons why the Bank should not raise rates. First, right now the downside risk on the demand side from Brexit surely exceeds the upside risk. Second, as the OBR chart here shows (look at orange bars), after a pause in 2017 austerity is planned to return in 2018 and 2019. Combining fiscal and monetary tightening in a boom would make sense, but we are currently in an economic downturn, with GDP per head growing this year at a third of its average pace since the recession of 2009. [1]

Finally, it is always important to consider risks. Suppose earnings growth does pick up sharply just after the MPC’s monthly meeting. The Bank always says it wants to be ‘ahead of the curve’, to avoid too rapid an increase in rates. This is the mentality that has led inflation to undershoot in the US and Eurozone since the recession, and if you take out the impact of depreciations by looking at the GDP deflator the same is true for the UK. The problem for the UK economy since the recession has not been too much inflation, but far too little demand.


[1] Specifically, average growth in 2017 is 0.1% per quarter, and averaging quarterly growth rates from 2010 Q1 to 2016 Q4 gives 0.3% per quarter          

8 comments:

  1. I think you are wholeheartedly right here but, as you say, it is a view that is contra to the MSM.

    To me the parallel is 2011 when we had inflation of 5.2% (?) and the bank stood pat. They were right to do so as there was no sign of second round effects on inflation and that the rise would disappear within a year. A rise now would simply exacerbate a situation where, as you rightly say, things are going south; it would be not merely pointless but counterproductive.

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  2. This is a great summary. The only thing I would wish to add would be the accounts position of major corporations. Perhaps what is also determining their investment behaviour besides demand conditions is the necessity to borrow. If they have a lot of internal funds (they are cash rich) there have little need to borrow. We could have a situation like Japan in the 2000s where banks were hesitant to lend except to a few privileged firms with good credit positions who did not need the cash anyway.

    NK.

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  3. Probably best to raise interest rates.
    You will notice that the interest if you want a loan from a bank is >> the rate if you want to lend to a bank.
    Time to bring some normality to proceedings. Like having interest rates > inflation.

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  4. "In particular, both investment and productivity growth are much lower than the Bank were expecting before Brexit."

    Bank forecasts can hardly be said to be wrong because of something? The predicted rise in productivity never happens [since GFC]? Sterling has been trashed for nearly 10 years now and the last 10% is so much more significant than prior 20+?

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  5. More preaching to the unconvertible, Simon ?

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  6. We are still bouncing along the bottom of a depression, the only way out is to get this government out and start reconstructing a manufacturing base.

    Invest in public services and tax the rich until the pips squeak, to quote one of the first monetarist ideologues Dennis Healey.

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  7. "The Sun" and the "Daily Mail" would be full of leaks if the 58 impact studies---that the Government is refusing to release---showed that Brexit was going to have a positive effect.
    Will the Brexit negotiations favour the UK by keeping the studies secret? Isn't it likely that the EU has done its own impact studies and knows exactly what is going on?

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  8. The most interesting thing about the judgment I would say is the claim that the UK's potential growth rate is 1.5%, surely that is very low and growth could be faster without adding to inflationary pressures?

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