Central banks still spooked by the ghosts of the past

Richard Jeffrey looks at the differences between how the US and the UK treat monetary policy


Richard Jeffrey

Richard Jeffrey

Chief Economist

The recent increase in interest rates announced by the Bank of England leaves us with no more clarity about the direction of monetary policy than we had before the micro-adjustment. Indeed, the increase raises rather more questions than it resolves. Ostensibly, the 0.25% move simply reverses the rather ill-judged post referendum cut. However, we have no clear understanding of whether we are at the start of a sequence that will see regular increases in rates along a path towards normalisation or, alternatively, whether this move was simply a nod to those worried about inflation becoming more embedded. If the former, how will the sequence emerge; if the latter, to what extent will the Monetary Policy Committee’s (MPC) nerve be tested by future trends in consumer prices?

The real question relates to the collective mood of the MPC. In the United States, it would seem that there has been a swing in sentiment about the Federal Reserve. Following the first rate rise there – in November 2016 – the Fed published projections showing that the intent was to edge up rates very gradually over the forthcoming few years. Nonetheless, it was still rather more focused on the risks rather than the rewards of normalisation. As a result, it continued to look for excuses to temper the pace of the tightening. Earlier this year there was a distinct mood change, and it would seem the Fed is now looking for reasons why it should not continue along the rate path it has projected. That is not to say that attitudes could not change again. However, it would appear that the Fed has become more confident in taking rates towards more normal levels it will not bring the economy to a juddering halt.

It seems unlikely that the MPC has yet reached its moment of Nirvana – or that it will reach it anytime soon. With some justification, it can claim that the position of the UK has been made more complex by the decision to leave the EU and the consequent increase in economic uncertainty. So, although the Bank’s inflation forecasts imply that rates will have to rise if the inflation target is to be met by the end of the forecast period, the MPC is unlikely to feel under undue pressure to ensure this through pre-emptive rate increases. In other words, when assessing the balance of policy, the MPC is still likely to regard the possible economic risks of higher rates as outweighing the potential rewards.

In public, we often see and hear the guardians of monetary policy congratulating themselves for taking the aggressive actions that helped the economy avoid the implosion that could have resulted from the financial crisis. In its more private moments, however, the committee must reflect on the fact that it presided over the policy environment that not just tolerated, but actively encouraged, the ruinous build up of debt that in large part caused the crisis. Economic historians will not be as reverential towards our policy makers as many commentators are today. But with that historical background, it is impossible for the MPC to make untainted policy decisions today. The MPC may be independent of government, but it is not independent of its history.

I think it is now clear that an extended period of unconventional monetary policy has not fostered the economic momentum that was envisaged. Economists at the Bank, defending the course that it has taken, constantly broach the so-called ‘counterfactual’. In other words, critics of policy should cease their reproaches, because they do not know how bad things could have been, had the current policy regime not been adopted. This, of course, is true of anything, at any time. Moreover, the counterfactual itself has no bias. While we may not know how bad things might have been, we also do not know how much better things could have been.

In my view, the extended period of low rates has reduced economic challenge and induced economic laziness. Nowhere is this more evident than in the very low rates of productivity growth that have been evident in all major advanced economies since the great recession. It is productivity growth that generates real wage increases and real profits growth. But negative real returns from cash and government bonds have created the lopsided position in which companies no longer have to compete for capital, so there is no pressure to take the risks involved in embarking on potentially productivity-enhancing capital investment. And investors are kept happy by cash-flow being pumped into dividends.

So, while UK policy makers continue to allow themselves to be haunted by the consequences of past policy mistakes, the US Fed seems to have adopted a more forward looking approach. If the reward is that productivity and growth momentum improve in the US as interest rates rise, other central banks may be jolted out of their policy comas.


Richard Jeffrey

Richard Jeffrey

Chief Economist

Richard Jeffrey was Chief Economist at Cazenove Capital until he retired in January 2018. 

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