2 November 2017

Why the Bank was right to raise rates


So, as expected, interest rates rose at noon. I’d have put them up by 0.5 per cent, but the Bank, instead, raised them by 0.25 per cent, to 0.5 per cent, on a 7-2 vote of the MPC.

We’ve had rates at near-zero since early 2009, when they dropped to 0.5 per cent after the financial crisis, and they were cut further to 0.25 per cent in August 2016 in a panicky move following the EU referendum result. So this is the first rate rise since 2007.

The Bank of England appears to be raising rates for a number of reasons: partly because it now accepts the August 2016 cut was unnecessary; partly because the US federal reserve is raising rates and the ECB is tapering QE, so internationally policy is tightening and the pound might fall further (creating more imported inflation) if the UK doesn’t join in; partly because inflation is above target and might go above 3 per cent, and partly because the Bank thinks a combination of underlying weak productivity growth and additional issues created by Brexit has reduced the potential output growth of the economy.

The Bank’s model forecasts GDP growth to be 1.6 per cent in 2017 and 2018, rising to 1.7 per cent in 2019 and 2020. That’s a little slower than the growth rate in recent years, but the Bank thinks the drop in the economy’s potential rate of output growth means even this modest growth is above-potential and hence could be mildly inflationary.

It states that the MPC will consider potential output growth in more detail as part of its “scheduled reassessment of supply-side conditions in the run-up to the February Inflation Report”. That might suggest February has been pencilled in for the next interest rate rise.

It’s pretty clear that the MPC is anticipating further rate rises. Its projection for inflation has it still above target right through to 2020, if interest rates stay at 0.5 per cent. Even at market interest rate expectations (of one rise in 2018 and another in 2020), that’s still true. A vote of 7-2 for a rise was towards the upper end of how decisive commentators had expected the MPC to be – and could be a hawkish signal.

How fast rates will actually rise depends very much on how the economy responds to this first rise and a second in 2018. If there is no real disruption, rate rises might turn out to be faster than expected (perhaps quite a bit faster). If the economy reacts badly to the rate, or disappoints in other ways, the Bank could yet content itself with only one more rise from here.

The economy is unlikely to react badly to the first two or three rate rises. Much commentary about “mortgage rates doubling” misses the point that, with rates so low, the vast majority of mortgage payments at present are the repayment of the principal, not the interest. A rise of 0.25 per cent in rates will raise the monthly payment on a £100,000 outstanding mortgage only by £13.

One area the economy could disappoint is pay growth. The Bank is expecting average weekly earnings to rise from 2¼ per cent now to 3 per cent in 2018 and 3¼ per cent in 2019 and 2020. That means the Bank is expecting wages to be growing a full percentage point per year faster than has happened at all since the 2008/09 Great Recession.

The Bank has its reasons for expecting faster wage growth – one of which is that its agents on the ground advise such wage rises are coming. Another, interestingly, could be lower net immigration.

Since this is a rather controversial topic, it’s worth quoting exactly what the Bank says:

Although changes in net migration affect labour supply, they also affect domestic demand. As a result, past shifts in net migration do not appear to have had a significant direct impact on slack or aggregate wage growth. But intelligence from the Bank’s Agents suggests that, were migration to fall abruptly, that could have more significant short-term consequences for supply — and hence for inflationary pressure — in some sectors that have become reliant on migrant labour.

So, in a nutshell, the Bank’s position is that past high net immigration has not depressed wage growth, but if net immigration were to drop back in the future, that might. Make of that what you will.

I would have raised rates more, and done so earlier. Having rates at the lowest possible level one can get away with is not a good monetary policy principle. Instead, rates should be at or close to their natural equilibrium level (roughly speaking, the sum of the inflation target and medium-term GDP growth rate — so, about 4 per cent, or perhaps a little less, at present) unless there’s a strong reason for them to be materially away from that level.

In other words, rates should automatically revert if times are reasonably stable. If rates do not so revert, that damages medium-term growth by allowing inefficiently-deployed capital to stay in unproductive uses. You can’t expect to keep interest rates at about zero for a decade without that damaging productivity growth.

It has been several years since the UK was in any economic or financial emergency that justified keeping rates at an emergency level. There is no economic emergency now, either. That doesn’t mean rates should suddenly rise to 4 per cent. But it does mean they should start rising. The Bank was right to take the first baby step on that path today.

Andrew Lilico is an economist and political writer