Straw that breaks the camel’s back

Econ­o­mist Paul Macflynn on why rais­ing in­ter­est rates dur­ing Brexit talks will be dam­ag­ing

Belfast Telegraph - Business Telegraph - - Front Page - By paul mac flynn, se­niore­conomis­tat­neri @PMACF_NERI

In­ter­est rates have been mak­ing the head­lines in re­cent weeks, as spec­u­la­tion mounts about a pos­si­ble change in pol­icy this Thurs­day. In the UK, the Bank of Eng­land base rate has been at an all-time low for al­most 10 years.

Mon­e­tary pol­icy has been very loose since the Great Fi­nan­cial Crash of 2008, not only in the UK, but around the world.

Low in­ter­est rates were also sup­ple­mented by a process of quan­ti­ta­tive eas­ing de­signed to free up even more money in the sys­tem by al­low­ing cen­tral banks pur­chase less risky as­sets such as bonds.

The eu­ro­zone econ­omy, which is now judged to be on the mend and head­ing to­ward more sus­tained growth, has been a ben­e­fi­ciary of this pol­icy.

Most econ­o­mists at­tribute the turn­around in the eu­ro­zone’s for­tunes to the ac­tions of Mario Draghi, when he be­came Pres­i­dent of the Euro­pean Cen­tral Bank in 2011.

He pledged to do ‘what­ever it takes’ to res­cue the euro cur­rency and it is thought that such a com­mit­ment put a floor on the eu­ro­zone cri­sis and al­lowed re­cov­ery to take hold.

In the US, low rates and QE be­gan with Ben Ber­nanke and were con­tin­ued by his suc­ces­sor, Janet Yellen, who has been loath to tighten mon­e­tary pol­icy, even in the face of what has ar­guably been a more ro­bust re­cov­ery.

Loose mon­e­tary pol­icy has there­fore played a sig­nif­i­cant role in build­ing the global eco­nomic re­cov­ery, such as it is.

Low in­ter­est rates are good for mort­gage hold­ers and peo­ple who like to buy now and pay later.

They are bad for peo­ple who like to save and par­tic­u­larly those plan­ning for re­tire­ment. Not ev­ery­body likes low in­ter­est rates.

As the global econ­omy has be­gun to re­cover, some have ar­gued that the time has now come to re­turn mon­e­tary pol­icy to nor­mal and be­gin rais­ing rates.

This is not only to ap­pease fret­ting pensioners, it is also nec­es­sary to en­sure that when the next re­ces­sion comes (and it will) that there is room to cut rates.

This has led to sig­nif­i­cant pres­sure on Ms Yellen over re­cent months and it is likely that her im­mi­nent re­place­ment will be quizzed by Congress on how quickly he or she will be­gin the process of rais­ing rates.

In Europe, Mr Draghi is un­der even more pres­sure from the in­fla­tion-averse Ger­man Bun­des­bank to be­gin un­wind­ing QE and even­tu­ally lift rates.

As both of these economies are con­sid­ered to have weathered the eco­nomic storm, the pres­sure for a move on rates is some­what un­der­stand­able. That a clam­our to raise rates in the UK has been gath­er­ing a pace is a rather more cu­ri­ous af­fair.

In the af­ter­math of the Brexit re­sult, Gover­nor of the Bank of Eng­land Mark Car­ney’s first ac­tion was to cut rates in or­der to sta­bilise the econ­omy.

Why in the midst of the cur­rent Brexit un­cer­tainty would the Bank of Eng­land see fit to raise in­ter­est rates?

One of the most ob­vi­ous rea­sons is that in­fla­tion has come back with a bang. Con­sumer Price In­fla­tion was run­ning at 3% in Septem­ber this year, up from 1.0% in 2016 and -0.1% in 2015.

In the clas­sic in­fla­tion sce­nario, too much money is chas­ing af­ter a lim­ited amount of goods and this pushes up prices.

Rais­ing in­ter­est rates makes it harder for peo­ple to bor­row and makes it more at­trac­tive to save, thereby tak­ing money out of the sys­tem and eas­ing the pres­sure on prices.

How­ever, this cur­rent bout of in­fla­tion is not linked to a con­sumer splurge.

It is di­rectly re­lated to the fall in the value of ster­ling, which by this time last year had lost as much as 16% of its value and is at present still 12% below its pre-brexit value.

Rais­ing rates in or­der to tackle an ex­change rate-in­duced bout of in­fla­tion would seem quite mis­guided.

Rais­ing rates will lead to a con­trac­tion in eco­nomic ac­tiv­ity as money is taken out of the econ­omy.

It would only there­fore be sen­si­ble to raise rates if there were signs that the econ­omy might be over­heat­ing now or in the near fu­ture.

Last week’s GDP fig­ures showed that the UK econ­omy grew 0.4% in the third quar­ter of this year. There was much ex­cite­ment sur­round­ing this re­lease, as it was a full 0.1% higher than most fore­caster’s ex­pec­ta­tions. How­ever, all things are rel­a­tive.

The third quar­ter re­sults only look good be­cause they beat ex­pec­ta­tions.

If you look back at quar­terly growth in the two years prior to Brexit, 0.4% is noth­ing to be­come ex­cited about.

Wages don’t sup­port the over­heat­ing the­ory ei­ther.

Pay pack­ets were be­gin­ning to re­cover slowly fol­low­ing a pro­tracted slump in the wake of the 2008 crash and had started to edge ahead of in­fla­tion.

That is un­til Brexit came along. Data re­leased last week showed that full-time wages in North­ern Ire­land fell by 1% last year when ad­justed for in­fla­tion.

If the econ­omy is on such a shaky foot­ing, why then would any­one want to raise rates and risk top­pling ev­ery­thing over?

There is an­other school of thought about the im­pact of pro­longed low rates.

Some peo­ple be­lieve that, as with all cures, it is nec­es­sary to en­sure that the pa­tient does not be­come hooked.

It is ar­gued that cer­tain busi- nesses are merely be­ing kept alive on cheap credit and that this is pulling down pro­duc­tiv­ity by pre­vent­ing the restora­tion of the nat­u­ral or­der in the busi­ness cy­cle.

There is a lot of merit in this propo­si­tion. Ul­tra-low in­ter­est rates are a sta­bil­i­sa­tion mech­a­nism, not a tool for growth.

If any­thing, the cur­rent predica­ment shows the lim­its of what mon­e­tary pol­icy can do.

Mon­e­tary pol­icy stopped the world from cav­ing in, but it can­not build the next phase of growth.

The next phase of growth has to come from in­vest­ment, in­no­va­tion and co­or­di­na­tion. Fis­cal pol­icy is the tool to achieve these ends.

De­vel­oped economies are cry­ing out for in­fra­struc­ture in­vest­ment and the chal­lenges of cli­mate change are too com­plex to be left to mar­ket forces.

Gov­ern­ment ac­tion is needed to lift the econ­omy to­wards it po­ten­tial and safe­guard it against fu­ture shocks.

Rais­ing in­ter­est rates next month would there­fore be a mis­take.

The Brexit ne­go­ti­a­tions are pro­vid­ing too much un­cer­tainty and the cur­rent UK gov­ern­ment shows no signs of us­ing fis­cal pol­icy to drive growth in the medium term.

Rais­ing rates now might be the straw that breaks the camel’s back.

In next week’s Econ­omy Watch, we hear from Es­mond Birnie of the Ul­ster Uni­ver­sity eco­nomic pol­icy cen­tre

Un­cer­tainty re­mains in the UK af­ter the Brexit vote and (right) Mario Draghi

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