Why would the Bank of England cut interest-rates right now?

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.

Inflation

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.

Comment

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?

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26 thoughts on “Why would the Bank of England cut interest-rates right now?

  1. Hi Shaun

    I also read the Simon W-L post and, like you I was not convinced.

    What I notice is that the present situation is called the ZLB by most commentators despite the fact that we are not actually at the Z point and that raises the question to my mind as to what effect a cut would have at the present juncture. As you say it doesn’t seem to matter where we are the medicine is an interest rate cut and if we are indeed in trouble – which I would agree with – would a cut of one quarter or one half percent make any difference? Frankly I can’t see it except that, as you say, it would increase the debt stock at the margin which would simply compound our current problems.

    These intellectual acrobatics indicate to me that we really are in somewhat of a hole and that the policy makers are flying blind, although they would never admit it. As I have said before I do not think the CBs will ever raise rates until they are forced to and I’m inclined to think that they would tolerate quite high rates of inflation to erode debt burdens before they act on rates.

    We have a debt based economy with secular trends towards lower consumption and ever more reckless lending is the only way to keep the show on the road but of course this also has a limit and when we reach that limit – kaboom!

    • We have a debt based economy with secular trends towards lower consumption and ever more reckless lending is the only way to keep the show on the road but of course this also has a limit and when we reach that limit – kaboom!

      Would consumption increase naturally if there were more widely-distributed disposable incomes?
      Would a helicopter-drop have worked better than years of QE? I can’t shake off the notion that it might have been more productive, like a little squirt of WD40 in the distributor cap. (I know I’m showing my age here!)

        • Ceteris paribus the marginal propensity to consume of the lowest quintile in the income distribution is probably much more than the first quintile so the answer to your question is probably yes, but of course redistribution is somewhat of a dirty word these days and seems to have less and less traction politically, despite the recognition of inequality as being dysfunctional economically.

          Personally I think direct QE to directly fund infrastructure would be a better bet than what we’ve had so far. Helicopter drops to the proles would seem to be encouraging them in profligacy and that would never do!

          BTW the secular trends re lower consumption are related to aging populations, not only in the West but also in China and Japan (with a vengeance!)

        • does raising the basic tax threshold count ?

          I think it does – can’t pay ’em more so tax them less

          still had as much effect as 375 billions of QE though

          Forbin

      • I think there have been helicopter drops of cash masquerading under pseudonyms such as “increased personal allowance” as Forbin points out and “Payment Protection Insurance compensation”. Same thing, different name.

    • Hi BobJ

      In my opinion there is a big issue with the Zero Lower Bound. It was previously considered to be 0% and if we are generous near to 0%. But now we have countries who are below it and in the case of Denmark and Switzerland well below it at -0.75%. Interestingly the IMF suggested “further monetary easing” for Switzerland a few hours ago. Is it hinting at -1% or -1.25%.

      So the bound was never 0% which kind of makes my point as the danger is of ever lower interest-rates in a downwards spiral. Meanwhile in some intellectually far away place Governor Carney has regularly stated that the lower bound for the UK is 0.5%.

      But apart from him ZLB is plainly NLB but how far?

  2. Re “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”, there is probably no inflation-targeting central bank in the world where the parameters are more completely controlled by the politicians, not the central bankers, than the Bank of England. The US Fed made it own call on adopting an IT regime in 2012, choosing its own target rate (2%) and target indicator (PCEPI) and so forth. The Bank of Canada renews an inflation-control agreement with the Department of Finance every five years or so (there is one next year). Although the Finance Minister will, if politically convenient, argue that this is really not his territory, this is just a political pretense. As former governor John Crow wrote: “In the periodic business of agreeing to reset the targets, the minister demonstrably has the upper hand.” The Chancellor of the Exchequer delivers the remit for the IT regime and the Bank of England works within the guidelines that were set for it. If it weren’t for Gordon Brown, the Bank of England might still be targeting the RPIX rather than the CPI. It is a real shame that monetary policy was not an issue in the UK election given that the existing remit is dubious, as you have frequently pointed out in your blogs.

    • Hi Andrew

      The question of the Bank of England being the “independent” central bank under the most political control is an interesting one? As you say it supinely accepted the switch in target from RPI to a CPI with no owner-occupied housing element and then the housing market bubbled. Each year it gets a new mandate from the Chancellor and whilst the new one is late I guess that was election driven. I would say the Bank of Japan pips it with the QQE (quantitative and qualitative monetary easing ) of Abenomics but it is a much closer run thing than one might easily assume.

      On that subject the UK Pound £ went above 190 Yen for a time today, it’s been a while…

    • Here in New Zealand the inflation target is negotiated between the Reserve Bank and the Government – Here’s the relevant bit from the RBNZ website :

      “The Reserve Bank Act requires that price stability be defined in a specific and public contract, negotiated between the government and the Reserve Bank. This is called the Policy Targets Agreement (PTA). The current PTA, signed in September 2012, defines price stability as annual increases in the Consumers Price Index (CPI) of between 1 and 3 percent on average over the medium term, with a focus on keeping future average inflation near the 2 percent target midpoint.”

      The PTA is an agreed document and it sounds an equable process, but the fact is that the Government can override the PTA if needs be; and if a PTA cannot be negotiated the Government can dismiss the Govnr.

  3. Bearing in mind what has happened to annuities over the past decade, target inflation @ 4% and overshoot by as much as we did between Jans. 2008 and 2014, bearing in mind the REAL price inflation of necessities during that period, and you’ll have pensioners out on the streets with pitchforks before long.
    Bank of Mum & Dad will be like Empiriko Trapeza.

    • They will try to avoid the inflation route for as long as possible as part of the “no boomer perturbed” core policy.

  4. Hi Shaun,
    An interesting and topical one today, since we have learned house asking prices have risen in London by some 17% since the election.

    http://www.telegraph.co.uk/finance/property/11631377/London-asking-prices-jump-17pc-after-the-election.html

    This being the case it seems quite clear to me that big mortgage interest rate cuts are urgently needed (and even better go negative), combined with further government assistance via Help to Buy, FLS etc. If this is not forthcoming then how will Londoners ever be able to afford to buy a house?

    Oh… wait etc…

  5. Extending credit is predicated on the ability to make the monthly repayments. With rates cut from 0.5% to 0.25% we would see the interest component halve. This is not the same as cutting when at 4.5%.

    • Hi Benfitzg

      We could keep playing that game on the way to 0% but of course most market rates are higher so we would be cutting from a higher base. Except here is the rub would the market rates necessarily fall? I have been following mortgage rates in Switzerland and they have not responded to the recent cuts as much as say Professor Wren-Lewis would apparently assume. We cannot exclude the possibility that they might even rise.

      So whilst I disagree with the policy the FLS of the Bank of England was in fact a much brighter move than the Bank Rate cut suggested by the Professor….

      • Agreed on real rates. FLS was brought in as I recall because mortgage rates were rising ahead of the overnight rate.

  6. off topic, but a day to celebrate 3 recent steps against corrupt governance. They’ve charged someone for LIEBOR, the Spanish voters have sent a twisted sister message to their pollys “if that’s your best, your best won’t do” we’re not gonna take it … and a few people at FIFA have had a bad day

    • Hi ExpatnBG

      Yes whilst it is too early to say that the worm has turned it was a bad day for corruption. I especially welcome the FIFA move as that has been a bastion of corruption for years where even being caught with envelopes stuffed with cash is apparently okay. The awarding of the World Cup to Qatar was breathtaking.

      Meanwhile maybe your list was one short.

      “Former UK Prime Minister Tony Blair is to stand down from his role as Middle East envoy representing the US, Russia, the UN and the EU, sources confirm.
      He will leave the role next month after he fulfils “outstanding commitments”, a source close to Mr Blair told the BBC.”

      I never could quite grasp the concept of him being a peace envoy. Perhaps the BBC no longer can either as I note the word peace was missing….

      • anti-corruption efforts require continual vigilance. the best we can hope for is a setup like the UK traffic police, where attempts at bribery are likely to result in arrest. In parts of Southern Europe accepting bribes is routine and even necessary to put food on the table 😦

        As to Tony Blair. Has he prevented any settlement construction ? Has he achieved any notable peace agreements ? Or is he just an overpaid underachiever ?

  7. “Why would the Bank of England cut interest-rates right now?” Why indeed, very unlikely imo. I doubt the BOE will take Wren-Lewis’ argument seriously. There is no labour slack any more except in unskilled jobs. Employers are now struggling to fill higher skill vacancies and those jobs are already experiencing substantial pay increases whilst unskilled continue to have virtually zero increases being mainly influenced by CPI which is currently….oh.. that’s it minus 0.1%!

    • Hi Noo2

      I agree completely that the slack or “output gap” argument has real issues right now if you look at the UK labour market. To argue that there is a 15% gap there has real issues as you point out.

      However should the UK economy slow there is a group at the Bank of England including Andy Haldane that could easy push for more easing.

  8. Not one commentator will face the issue that 375billion has been robbed from all those who depend on income from savings it matches the QE which benefitted the rich

    The millions of mostly elderly who rely on savings income because they have no other form of pension than often only half state pension are now in dire straits and simply cannot spend and dare not dip into capitol because they have another 20 or 30 years to fund so theres a massive loss of consumption thats ignored because the NMG survey that Bof E rely on is totally flawed

    What the B of E are doing is deliberately robbing the prudent to prop up feckless debtors instead of facing the real issue that low interest rates simply increases debt and pushes the can down the road.
    The young have no hope of saving a deposit , the elderly cant afford to help the young and the middle are now doing very nicely thank you because the personal tax allowance has been increased

    Since the elderly do not even have an income of £10,600 they get zero benefit at all from any of the other changes

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