Today sees the publication of the Queen’s Speech in Parliament which will deal with issues of fiscal policy but I wish to look at the consequences for monetary policy. After all monetary policy was something which did not get much of an airing in the election debates because it is accepted that this is now controlled by the Bank of England. Actually there is a technical problem with that as it needs permission from the Chancellor of the Exchequer for its QE (Quantitative Easing) program. Also it is rather a moot point as to how different UK monetary policy would be if we had politicians in charge as they would have eased policy considerably too. On that road you find yourself facing the fact that any argument for “independence” at the Bank of England involves them being able to ease monetary policy by more than politicians would have done! Was that the whole (political) plan all along?
The case for a Bank Rate Reduction
Regular readers will be aware that I have argued since December 2013 that a Bank Rate cut is as least as likely as a rise. This is of course against the consensus because the “Forward Guidance” of the Bank of England promises a rise. But I would like to visit the Ivory Tower of Professor Wren-Lewis to examine his case for a Bank Rate cut. His view is that we have a large output gap right now and that we should use monetary policy to help close it.
The most basic thing we know about the UK economy is that output is now something like 15% below where it should be if pre-recession trends had continued. For the UK that pre-recession trend had been remarkably stable………So it is possible that the scope for additional expansion is large. This is real uncertainty, but it is also one sided uncertainty. No one is seriously suggesting the economy is running at 5% above trend, let alone 15%!
We also have a discussion on inflationary trend where the good Professor seems to have confused himself so let us move quickly onto productivity which he also feels would improve with a demand boost via a rate cut.
but such improvements would come quickly if demand picked up enough (and labour became scarce). Again the risks here seem one-sided.
If we combine the two factors then it is clear as to why the Professor argues strongly for a Bank Rate cut now.
In these circumstances, the obvious thing to do, as well as the cautious and prudent thing to do, is to cut rates now to cover for the possibility that the output gap is actually much larger than estimated and inflation will therefore not return to target as hoped.
There you have it in a nutshell. There are other cases for a UK interest-rate cut which involve raising the inflation target to 4% per annum made by other Professors but I will respond to those by simply pointing out UK economic history.
Let me add a case which is not made by the Professor which is the strength of the UK Pound £ exchange-rate. He seems unclear about its impact so let me help him out. We have seen a surge in the value of the UK Pound since the nadir of March 2013 and in fact have even risen above the level it was at when Lehman Brothers collapsed. Using the old Bank of England rule of thumb the rise has been equivalent to a 3.5% increase in Bank Rate. Care is needed as it is only a rule of thumb but it does indicate a clear tightening over the past couple of years.
The argument against
The simplest is that if we move from an Ivory Tower world of official interest-rates to the world in which we live interest-rates have been falling since the implementation of FLS or the Funding for (mortgage) Lending Scheme in July 2012. For example the 2 year fixed rate mortgage (90% LTV) fell from over 6% in early 2012 to 3.53% at the end of April according to the Bank of England. Which influences the economy more Bank Rate or mortgage rates? There is perhaps an answer in the fact that Bank Rate has not changed for six years.
Accordingly we already have a much more complex environment than the Ivory Tower simplicity of pulling a Bank Rate lever. For our trading companies life has got harder overall via a currency rise whilst for the housing and consumer sector it has got easier. Along this road of course we do get the worries about rising household debt and unsecured lending which I note do not get a mention in the case for an interest rate cut.
Next we have the issue that the economy is growing rather solidly right now and of course has just received a boost from the oil price drop.
GDP was 2.4% higher in Quarter 1 (Jan to Mar) 2015 compared with the same quarter a year ago.
It was not so long ago that such a rate of growth would have led for calls for a consideration of monetary tightening and not a cut! I wonder what rate of growth would now be enough?
Are we targeting inflation or economic growth?
I note the use of the “deflation” spectre by the Professor. This links to an article by David Blanchflower on the subject which seems to predict the end of the world as we know it on the basis of one monthly CPI annual print of -0.1%. What about the years of above target inflation? Or these issues?
The all items RPI annual rate is 0.9%, unchanged from last month.
UK house prices increased by 9.6% in the year to March 2015, up from 7.4% in the year to February 2015.
So on these measures we have a mild slow down in inflation and a rampant episode of asset price inflation. Are they the new definition of deflation? We should be told if so especially as the major price fall (oil) is one about which we can hardly defer purchases unless someone can show me a way of doing that with my car when it runs out of diesel or domestic heating?
So we have a clear issue which is that when economic growth is poor and inflation high we are told we need an interest-rate cut because of growth. Now we have low inflation and much better growth we need a rate cut because inflation is low. The Starship Enterprise would be on red alert with such asymmetry.
The Output Gap
In many ways this blog opened as an argument against the output gap and I was proven to be correct. Accordingly after the years of pain for its adherents when inflation was supposed to collapse and instead went above 5% per annum which was quite an anti-achievement in my opinion you might expect some revisions. For example an acceptance that some and worryingly much of the pre credit crunch boom was as the band Imagination put it.
Just An Illusion
Instead just like The Terminator it is apparently back! Sadly nothing appears to have been learned.In my opinion there is no trend anymore as the pre credit crunch period has gone and we need to adjust to that otherwise we run the risk of making the mistake that Japan made that somehow it might come back.
Another issue with saying output has a gap is this.
In quarter 1 January to March 2015, the UK’s deficit on trade in goods and services was estimated to have been £7.5 billion; widening by £1.5 billion from the previous quarter.
Tucked away in the interest-rate cut analysis is a completely different view of the economic damage inflicted by bursts of inflation on the ordinary person, worker and consumer.
The worst that can happen if this is done is that rates might have to rise a little more rapidly than otherwise in the future, and inflation might slightly overshoot the 2% target.
Borrowing from the future as the can gets kicked again? However if I may just stick with the inflation point this is a repetition of the output gap error made in 2009/10/11 again as “slightly overshoot” became 5% per annum inflation and begat a collapse in real wages. That road forwards became this as real wage falls became a depressionary influence on the UK economy.
We’re on a road to nowhere
Anyway aren’t services four-fifths of our economy?
The CPI all services index annual rate is 2.0%……The all services RPI annual rate is 1.8%
Cutting interest-rates is a trap
The problem with cutting official interest-rates is that you end up in the situation described by Coldplay.
Oh, no, what’s this?
A spider web, and I’m caught in the middle,
So I turned to run,
The thought of all the stupid things I’ve done,
We cut from 5% to an emergency rate of 0.5% and now we need to cut again apparently. So is this a worse emergency? This would need quite an explanation right now! Especially if you throw in the fact that back then we got quite a boost from a lower pound too. Overall monetary policy is very loose and if you throw everything into the pot (QE etc) what would you say the Bank Rate equivalent is -5%?
Now we get to the difficult bit. The first part is that via the effect on savers interest-rate cuts here have only a small effect and may have a reverse effect. Secondly as we keep cutting and debt rises in response how can we ever raise rates again without a collapse?So we cut again as we find ourselves in the spider’s web described by Coldplay.
If Professor Wren-Lewis is correct and we can improve things by pulling a lever then it is time for one of the Beach Boys hits.
Wouldn’t it be nice
Maybe if we think and wish and hope and pray it might come true
Baby then there wouldn’t be a single thing we couldn’t do.
Except if pulling levers like that did work we wouldn’t be where we are would we?