Strategy & economics

The art of policymaking

17/04/2014

Richard Jeffrey

Richard Jeffrey

Chief Economist

With increasing signs that the economy is gaining significant momentum, the MPC should start to contemplate taking the first steps towards normalising monetary policy. Stated bluntly, the MPC should now start raising interest rates.

If policy decisions are made only when it is entirely obvious, then we could leave interest rate setting to machines. The art of policymaking is to develop an understanding of prevailing trends, to anticipate where the economy may be headed, and then to make policy choices on the basis of the environment that is expected to have developed in one, two or three years’ time.

It was concerning, therefore, to look at the Bank of England’s latest forecasts for the real economy – those based on unchanged interest rates. In February, the Bank forecast that growth this year would be 3.8%, followed by 3.2% in 2015 and 2016. If the MPC really believes this, then it should be raising interest rates now; no debate. If the MPC does not believe these forecasts, why were they published?

I doubt that growth will be as strong as the Bank of England is suggesting, even were interest rates to be left unchanged over the whole period. Nonetheless, I think that the MPC should be giving serious consideration to raising rates over the coming few months. After such a shock to the economic and financial system, it is unsurprising that policymakers around the world remain extremely risk averse. Neither is it surprising that they still regard the greater risk as being stifling a recovery by raising interest rates too early. But I believe the risks are now tipping in the reverse direction – that the greater risk has shifted towards raising interest rates too late and in monetary policy finding itself behind the curve.

There is always a danger that policy is behind the curve. Because it takes so long (normally about a year) for a change in interest rates to feed through to real activity and a further year for this to impact the price level, it is vital that interest-rate-setting bodies keep their eyes firmly focussed on the economic horizon. In this policy cycle, the risks are all the greater because of the previous policy of quantitative easing, and the huge injection of liquidity into the system that this involved. To date, this addition of liquidity has had an obvious impact on some asset prices (hence, for instance, gilt yields are artificially low), but little measurable impact on the real economy. But the liquidity has not evaporated; it remains within the monetary system. As growth picks up, and banks and other financial institutions reassess their attitude to risk, the liquidity added through QE will have the potential to exert a much greater impact.

In my view, it was always likely to be the case that QE was likely to have its biggest influence on the economy once growth had started to gain momentum. We are now at that point, and policymakers have to ensure that a welcome pick up in activity does not turn into a liquidity-fuelled growth bubble, which would almost certainly lead to rising inflation and greater levels of excess demand. In judging this risk, it is not sufficient to look at data that is a month or more old, and conclude that everything seems ‘OK’ at the moment. We have to think about current trends, assess where they might take the economy over the next year or two, and then decide whether this should warrant the first steps now being taken towards tightening monetary policy.

And lest we place too much faith in our policymakers to always take the ‘right’ decision (and not wanting to go through the whole history of policy decision since 1997), it is worth remembering that it is not so long ago that several members of the Monetary Policy Committee were pressing very hard for QE to be resumed. On that occasion, the MPC got it right, but it was a close call.

So what should the MPC be taking into account now? Not inflation. As suggested above, inflation lags policy by about two years and growth by around a year. Low inflation rates now are a function partly of where the economy was a year (and more) ago and partly of trends in international energy and other import prices. Rather, we should be looking at developments in ‘real’ areas, such as demand, trade, the labour market, asset prices (especially housing), investment, and household confidence.

Virtually all these indicators are gaining momentum or pointing to significantly strengthening domestic demand. As such, they are all saying that we should think about bringing to an end the period in which monetary policy is exceptionally, in fact unprecedentedly,  accommodative. The labour market data provides some of the most compelling evidence of tightening supply conditions in the economy. The unemployment rate has fallen below 7% – below, the threshold, that is, which Mark Carney, Governor of the Bank of England, said previously would cause the MPC to start thinking about an increase in interest rates. Behind this, private sector employment rose 473,000 in 2013 and total employment in the year to February 2014 was up by 691,000. At the same time, job vacancies were some 21.5% higher than a year previously, topping 600,000 in the three months to March for the first time since 2008. With the labour market so buoyant, average earnings growth is picking up. Following increases of 1.4% and 1.5%, respectively, in 2012 and 2013, the year-on-year increase in the three months to February was 2.0%.

Adding weight to the conclusion that it is now time to start addressing tightening conditions in the economy, it needs to be recognised that, even on the Bank of England’s own estimates, spare capacity in the economy is very limited, at only 1% to 1½%. And currently projected growth rates can be matched against  the longer-term sustainable growth rate that we estimate to be between 2% and 2¼% (as does the Office for Budget Responsibility).

‘Tightening’ is a difficult word, given what we have just come through. So perhaps we should refer to the next policy stage as one of normalising monetary policy. I am certainly not saying that we should be looking to get interest rates back up to, say, 4% as soon as possible. But recent trends are suggesting very strongly that we should be starting to raise bank rate very gently from its crisis low of 0.5%.

In relation to both the real economy and the political cycle, normalising monetary policy will have to be done very delicately. It is self-evident that we do not want to undermine the recovery process. At the same time, leaving interest rates where they are as the economy builds up momentum will risk the recovery becoming more unbalanced. I had previously thought that the authorities might be able to delay raising rates until 2015 – and it remains more than possible they will still seek to do so. But I have come to the view that this would not be a good thing; that a balanced recovery requires interest rates starting to normalise as soon as practicable.

Whenever interest rates do start to rise, it will be a potential shock to the system. Arguably, however, the shock will be greater the longer that rates remain at their current level. The more debt that is taken out at current interest costs, especially by households, the greater will be the potential impact when rates do start to rise. We can already see in the housing market the manifestation of rising activity in unhealthy price movements (partly encouraged by government support). Almost always, trends in the housing market forewarn of wider economic developments; seldom has it been the case that rising house-price inflation has not been followed by a more widespread increase in inflationary pressure.

The UK still has a way to go in its healing process. But this does not mean that the stance of monetary policy should remain unchanged until we conclude that we are ‘back to normal’. Rather, in order to ensure that the recovery takes place in a controlled fashion, it is important that the authorities seek to control the recovery, not let it run on unchecked while patting themselves on the back for a job well done.

Of course, it will be politically uncomfortable when interest rates rise for the first time – but that is why we have an independent monetary policy process, run by the MPC, that takes interest rates out of the political frame.  More to the point, perhaps, the politicians ought to be able to point to rising interest rates as evidence that the economy is returning to normal.

Inevitably, there will be questions as to whether the UK should be raising rates before the US and while the ECB may yet institute its own form of QE. And of course there are risks – for instance that sterling will appreciate. But no change in monetary or fiscal policy is without risk. It is simply that risk has to be balanced against potential reward. If we can be sure of one thing, it is that the longer the MPC delays raising interest rates, the faster and probably higher they will eventually have to rise. And this is not to mention the potential longer-term necessity of beginning to reverse QE, a proposition that for financial markets, at the very least, is likely to be even scarier.

Whether the MPC will be brave enough to make an early move is another question. We suspect that it remains too focussed on what has happened (regretting, possibly, its own role in that) to consider taking delicate pre-emptive action. But the longer the MPC drives the economy forward while staring in the rear-view mirror, the more likely it is that it will fail to see the hazards ahead.

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