Why it would be wrong to blame a rate hike on Brexit
30 October 2017
SUGGESTED
Economic Theory
Brexit
31 October 2017
Trade, Development, and Immigration
4 November 2024
The Bank of England is likely, though not certain, to raise its official interest rate on Thursday. Many commentators think a rate hike now would be a mistake. In contrast, the Shadow Monetary Policy Committee, a group of independent economists meeting at the IEA, has already voted unanimously for an immediate increase. (I backed a hike from 0.25% to 0.5%.)
Some people will blame Brexit for any increase in interest rates. Their point is that the move would be due, at least in part, to the impact of the fall in the pound on the price of imports. Indeed, the CPI measure of inflation, at 3% in September, is now a full percent above the Bank’s 2% target. But this argument is actually pretty feeble.
For a start, the Bank only cut rates from 0.5% to 0.25% last August because of fears of a sharp downturn following the EU referendum. It makes little sense to blame Brexit for the reversal of a rate cut that was itself due to Brexit. The reality is that rates would only be returning to the level they were at before the vote to leave the EU.
What’s more, the rise in inflation alone would be a poor reason to raise rates. The pound has been relatively stable (on a trade-weighted basis) over the last twelve months. This means that inflation should fall back of its own accord over the course of 2018, as the effects of past currency weakness fade. The Bank would normally be expected to look through the rise in headline inflation, if this were the only factor.
It would be a lot more sensible to argue that interest rates would already have risen had it not been for Brexit. Growth has indeed been weaker than it would otherwise have been, due to the additional squeeze on real incomes from the fall in the pound and the drag on investment from uncertainty about the UK’s future relationship with the EU. But despite these headwinds, GDP has continued to grow at an average rate of 0.4% q/q in the five quarters since the Brexit vote, which is only slightly slower than the pace in the five quarters before.
What’s more, UK unemployment has continued to fall and, at 4.3%, is half the rate in the eurozone, while employment is at historic highs. Admittedly, average wage growth has been unusually subdued, but there are several good reasons to expect a pick up soon. For example, the BoE’s own economists have acknowledged that the headline figures here have been distorted by compositional effects. Short-term measures of private sector pay growth are already reporting an acceleration. And while others have made a lot of the truism that unemployment is higher if you use a broader definition, the bigger picture is that the labour market has continued to tighten regardless of the measure chosen. Even if the UK is not yet at ‘full employment’, there is no longer any need for interest rates to be held at emergency lows.
It is also wrong to assume that ultra-low interest rates are always good for the economy. Indeed, the longer that interest rates are kept at such low levels, the greater the costs from the misallocation of resources. For example, ultra-low rates may actually be undermining investment, both by forcing companies to divert money to offset pension deficits and by encouraging banks to speculate in financial assets rather than lend to the real economy. And again, even the Bank’s chief economist has recognised that ultra-low interest rates may be holding back productivity.
To be clear, any increase in interest rates will increase the strain on borrowers. This may only be partly offset by the benefit to savers, who are typically better off. However, a quarter point hike in the Bank rate is unlikely to have any significant impact on the cost of credit for most borrowers. The prospect of further increases may at least discourage others from accumulating further debt. Of course, some people have little choice, but there are better ways to help the most vulnerable than keeping interest rates at unsustainably low levels across the board. And if a rate rise does help to support sterling further, it may also help to end the squeeze on real wages.
The timing this week is good too. The bulk of the incoming economic data has matched or beaten the Bank’s expectations in its August Inflation Report. As a result, a November rate hike is now essentially priced in to the markets. In these circumstances, leaving rates on hold risks sending the wrong signal – either that the MPC thinks that the economic outlook is actually worsening despite the stronger data (hence undermining confidence), or that it will keep interest rates low come what may (boosting inflation expectations and encouraging financial excesses).
That said, a rate hike this week is not the done deal that many assume. There is a reasonable case for waiting to see the content of the Chancellor’s Budget in November and the outcome of the EU summit in December. This would be consistent with a rate rise early in the New Year.
Nonetheless, we can already be pretty confident that fiscal policy will be loosened further, meaning there is even less need for interest rates to remain low to offset the drag from ‘austerity’. As for the Brexit negotiations, the bias should be for additional tightening if they go well, rather than persisting with a rate cut that looks increasingly counter-productive. A hike this week could be balanced with a relatively dovish statement, thus providing reassurance that the Bank is willing to step up its support again – if indeed it does prove necessary.
Some people will blame Brexit for any increase in interest rates. Their point is that the move would be due, at least in part, to the impact of the fall in the pound on the price of imports. Indeed, the CPI measure of inflation, at 3% in September, is now a full percent above the Bank’s 2% target. But this argument is actually pretty feeble.
For a start, the Bank only cut rates from 0.5% to 0.25% last August because of fears of a sharp downturn following the EU referendum. It makes little sense to blame Brexit for the reversal of a rate cut that was itself due to Brexit. The reality is that rates would only be returning to the level they were at before the vote to leave the EU.
What’s more, the rise in inflation alone would be a poor reason to raise rates. The pound has been relatively stable (on a trade-weighted basis) over the last twelve months. This means that inflation should fall back of its own accord over the course of 2018, as the effects of past currency weakness fade. The Bank would normally be expected to look through the rise in headline inflation, if this were the only factor.
It would be a lot more sensible to argue that interest rates would already have risen had it not been for Brexit. Growth has indeed been weaker than it would otherwise have been, due to the additional squeeze on real incomes from the fall in the pound and the drag on investment from uncertainty about the UK’s future relationship with the EU. But despite these headwinds, GDP has continued to grow at an average rate of 0.4% q/q in the five quarters since the Brexit vote, which is only slightly slower than the pace in the five quarters before.
What’s more, UK unemployment has continued to fall and, at 4.3%, is half the rate in the eurozone, while employment is at historic highs. Admittedly, average wage growth has been unusually subdued, but there are several good reasons to expect a pick up soon. For example, the BoE’s own economists have acknowledged that the headline figures here have been distorted by compositional effects. Short-term measures of private sector pay growth are already reporting an acceleration. And while others have made a lot of the truism that unemployment is higher if you use a broader definition, the bigger picture is that the labour market has continued to tighten regardless of the measure chosen. Even if the UK is not yet at ‘full employment’, there is no longer any need for interest rates to be held at emergency lows.
It is also wrong to assume that ultra-low interest rates are always good for the economy. Indeed, the longer that interest rates are kept at such low levels, the greater the costs from the misallocation of resources. For example, ultra-low rates may actually be undermining investment, both by forcing companies to divert money to offset pension deficits and by encouraging banks to speculate in financial assets rather than lend to the real economy. And again, even the Bank’s chief economist has recognised that ultra-low interest rates may be holding back productivity.
To be clear, any increase in interest rates will increase the strain on borrowers. This may only be partly offset by the benefit to savers, who are typically better off. However, a quarter point hike in the Bank rate is unlikely to have any significant impact on the cost of credit for most borrowers. The prospect of further increases may at least discourage others from accumulating further debt. Of course, some people have little choice, but there are better ways to help the most vulnerable than keeping interest rates at unsustainably low levels across the board. And if a rate rise does help to support sterling further, it may also help to end the squeeze on real wages.
The timing this week is good too. The bulk of the incoming economic data has matched or beaten the Bank’s expectations in its August Inflation Report. As a result, a November rate hike is now essentially priced in to the markets. In these circumstances, leaving rates on hold risks sending the wrong signal – either that the MPC thinks that the economic outlook is actually worsening despite the stronger data (hence undermining confidence), or that it will keep interest rates low come what may (boosting inflation expectations and encouraging financial excesses).
That said, a rate hike this week is not the done deal that many assume. There is a reasonable case for waiting to see the content of the Chancellor’s Budget in November and the outcome of the EU summit in December. This would be consistent with a rate rise early in the New Year.
Nonetheless, we can already be pretty confident that fiscal policy will be loosened further, meaning there is even less need for interest rates to remain low to offset the drag from ‘austerity’. As for the Brexit negotiations, the bias should be for additional tightening if they go well, rather than persisting with a rate cut that looks increasingly counter-productive. A hike this week could be balanced with a relatively dovish statement, thus providing reassurance that the Bank is willing to step up its support again – if indeed it does prove necessary.
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