Interest rates at crisis levels

One of the adjectives more commonly used to describe the recovery is fragile. But does the supposed delicate state of the economy reflect its true condition or merely our perception – one still heavily influenced by the numbness induced by the preceding recession and financial crisis (any risk of a return to which we would want to avoid at almost any cost)? And, if the recovery is still fragile, what will be the traits that might emerge in the future that will lead us to conclude that it is no longer so brittle? I will leave that question hanging, since my conclusion is that the economy is not now so fragile that it cannot cope with the first steps being taken to normalise monetary policy. Indeed, I feel strongly that beginning to edge interest rates higher will not undermine the evolving recovery, but will make it more robust. A recovery that can be maintained only on the basis that bank rate remains at 0.5% will become increasingly flimsy. We will make the economy less vulnerable if, slowly, we take policy steps that allow it to acclimatise to a more normal policy regime. At the same time, beginning to take interest rates slightly higher will avoid the risk the growth once again becomes too reliant on debt-fuelled consumption and will give the authorities some scope for supportive policy action, should that be required at a later date.

Both the Treasury and the Bank of England (BoE) seem to think that the greater risk is in tightening too early. So, with the economy already growing at an annualised rate of around 3.5% and seemingly still gaining momentum, when will too early become too late? If changes in monetary policy had an instant impact on activity, the risks of delaying policy changes would be lower. However, the delay between a change in interest rates and its impact on growth is substantial (around a year) and there is a further lag before a change in the growth rate influences the price level. So, in judging what to do with interest rates today, we have to assess how the economy is likely to develop on a one-to-two year time horizon. We might suppose, of course, that the economy will prove more sensitive to interest rate changes in current circumstances. I doubt this, as I suspect that the first couple of quarter-percent changes in the BoE’s official bank rate will have a relatively limited impact on the structure of market rates. But to the extent there is a faster reaction, one of these being to induce some caution amongst individuals beginning to gear up with mortgage debt, it might be welcome.

The longer the economy is allowed to gain momentum unchecked, the greater the likelihood that we will experience a sharper-than-necessary slowdown in two-to-three years’ time. One of the surprising features of the recession was that it did not result in more spare capacity being released. But on the BoE’s own assessment, spare capacity is no more than 1.5% of GDP (the Office for Budget Responsibility estimates it was 1.7% at the end of 2013). At current growth rates, this will be largely absorbed within a year. If, as full capacity is reached, the economy continues to grow at a rate in excess of 3% (arguably, in excess of 2.25%), the probability that growth will begin to generate significantly higher inflationary pressure will rise appreciably.

The focus of the BoE’s Monetary Policy Committee should now be on the policy environment required to nurture a well-balanced recovery. Recent developments are both helpful and unhelpful in this context. Signs that companies are beginning to make use of balance sheet strength both to raise capital investment and to embark on a higher level of corporate activity are very positive, and indicate that we have moved into a new phase of the economic cycle – one that will be less reliant on policy help to maintain growth. At the same time, there is beginning to be too much heat in the housing market and there is also evidence that rising consumer confidence is feeding through to faster growth in spending. While I do not see either of these trends as significantly problematic at the moment, they will both become so if they are allowed to run on.

Setting interest rates is not the mechanistic process suggested by the Taylor Rule. That took us down a policy cul-de-sac. Monetary policy is as much an art as a science. The art is in getting the timing right, and in policy makers showing sufficient awareness of where current dynamics will take us if no action is taken.

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