Carney and co must come clean on the need for a rate increase
It would be a surprise if a rate hike on Thursday moved markets much. Through its official communications and speeches by key policymakers, the Bank of England (BOE) has encouraged markets to read between the lines that a rate hike could come this week. This has de facto allowed financiers to front-run the policy change and slowly adjust the prices of assets that are linked to monetary policy.
The City sees a roughly 90pc chance the BOE will raise its main policy rate later this week, probably to 0.75pc from 0.5pc. It would follow on from the hike last November, which simply reversed the cut to 0.25pc shortly after the Brexit vote.
The risks to the economy from a gradual rise in interest rates are extremely low. At this stage of the cycle, when employment is high and wage growth is starting to pick up, modestly higher interest rates can be good for the economy. This view is not widely held. Although the BOE has done a good job at preparing markets
‘The BOE is hiding too much behind its remit – to keep inflation steady at 2pc – in order to justify rate hikes’
for a hike, it is failing to make a strong case for why rates need to go up.
The press conference following the publication of the August Inflation Report and Monetary Policy Committee (MPC) meeting will shine a light on this gap in the bank’s communication strategy.
After announcing any policy changes, BOE Governor Mark Carney will take questions from the press. The key questions should be familiar for any Bank watchers: “Should the BOE really hike before we know what Brexit will look like?” And: “Can the household sector with all its debt really handle higher borrowing costs?”
That the questions are predictable shows the Bank has not yet answered them convincingly.
Ever since the BOE raised rates last November, its public-facing policymakers have reiterated the same message outlining the reason why interest rates are rising. According to the minutes of the June 2018 monetary policy meeting, the MPC thinks that an “ongoing tightening of monetary policy over the forecast period would be appropriate to return inflation sustainably to its target”.
This statement is problematic for two reasons. First, the term “tightening” is misleading. Second, the BOE is hiding too much behind its remit – to keep inflation steady at 2pc – in order to justify rate hikes. This might be convenient, but it fails to articulate the practical reasons why rates need to go up.
To the first problem: on its own, the central bank interest rate has no real bearing on whether monetary policy is “tight” or “loose”. What matters is the difference between the central Bank Rate and the equilibrium interest rate – the short-term interest rate that would keep the economy on a stable growth path at full employment.
By setting the central bank policy rate relative to this short-term equilibrium rate, the BOE aims to stabilise demand growth over the economic cycle. The key question is, what is the equilibrium interest rate?
On Thursday, the BOE will for the first time publish its estimate of the equilibrium interest rate. This is the latest addition to its overall efforts to be more transparent. The US Federal Reserve already publishes an estimate of this rate, known as “r*”. The Fed estimates that the US equilibrium interest rate is 2.8pc – or 0.8pc when adjusted for its 2pc inflation target.
Many factors determine the equilibrium rate, including long-run productivity growth, the balance of demand and supply of safe assets, and demographic trends. All of these factors in turn affect an economy’s growth potential.
Reflecting lower potential growth in the UK, the BOE is likely to announce a slightly lower equilibrium rate than the Fed estimates for the US. The Bank’s estimate will probably be around 2.5pc – or 0.5pc when adjusted for the 2pc inflation target.
Even if the BOE hikes on Thursday, the policy rate could be a good 1.75ppt below the equilibrium rate. Monetary policy would remain highly accommodative. In other words, no tightening yet.
By definition, as long as the economy is running at full capacity, monetary policy would only be tight if and when the Bank Rate exceeded the Boe’s estimate of the equilibrium rate.
If, as seems likely, the Bank ups the pace of rate hikes to two per year in 2019 and 2020 as the Brexit uncertainty fades, monetary policy will remain accommodative for a long time yet. A more appropriate description of the Boe’s current policy would be, therefore, that monetary policy is becoming less expansionary. Or, better still, that monetary policy is normalising. Either would help avoid the misleading impression – that the Bank is currently giving – that rising rates will take steam out of the economy in a major way.
Of course, too much transparency has drawbacks. Giving precise estimates of key variables can risk undermining the Boe’s credibility if, by some surprise, it had to deviate from a policy path implied by those estimates. However, as we gradually escape the long shadow cast by the financial crisis and return to something resembling normalcy, outlining what just normal means is a step in the right direction.
To address the second problem, namely the awful habit of hiding behind the safety of its inflation target when justifying higher rates, the BOE should seek to explain why the economy is set to benefit from them.
As the economic cycle enters its second phase, the widespread benefit of a steady normalisation of monetary policy which keeps the economy from overheating exceeds the concentrated costs to those with unsustainable debt burdens. The key point is that well-timed rate hikes can lengthen the economic cycle and keep people in work for longer.
In the early days of a rate hike cycle, central banks must tread carefully. Markets, households and firms may worry more than they should about the impact of higher rates. Over time, these worries will fade. Eventually, the psychology may completely flip. Then, a pause or slowdown in the pace of rate hikes may stoke fears that the economy is headed for trouble. As far as the typical rate hike cycle goes, however, all of this is normal.
Kallum Pickering is the senior economist at Berenberg