The BoE and a bit of cold turkey

It is widely expected that the Bank of England will raise interest rates this week for the first time since 2007. There have been some influential academic voices suggesting that this would be the wrong time to raise rates – the more I think about it, the more I disagree with them. And before we all get carried away, the expected increase from 0.25% to 0.5% would only represent a move from the lowest level in history to the second lowest.

The first reason for disagreeing with some of the wiser heads is purely to do with the signalling effect. Having suggested in September that “some withdrawal of monetary stimulus was likely to be appropriate over the coming months” financial markets have increasingly interpreted this as meaning that a rate move is likely in November and are now pricing such action with a probability of almost 90%. Although the BoE has suggested in the past that a near-term rate hike might be in the offing – which subsequently never materialised – not since Mark Carney assumed his post in 2013 have markets been so convinced about the likelihood of a rate hike at the upcoming meeting as they are now. The only comparable degree of market conviction was in the wake of the EU referendum, when in July 2016 markets fully priced a 25 bps rate cut at the August 2016 MPC meeting (a reduction which was duly delivered).

Of course, it is not the MPC’s job to reinforce the market’s conviction. But to the extent that the strategy of forward guidance relies on the predictability and credibility of central bank communication, any decision to hold interest rates unchanged in view of current market expectations would seriously undermine this plank of monetary policy because it would suggest that communication has not been sufficiently clear.

Another strong argument in favour of raising interest rates is that they are (arguably) too low given where we are in the economic cycle. Much of the academic opposition to a rate hike stems from the fact that wage inflation remains low, and uncertainty surrounding the Brexit decision suggests that this is not a good time to tighten policy. I have sympathy with these views. Indeed, I have argued recently that the inflation excuse used to justify the need for higher interest rates does not wash because it reflects a one-off spike triggered by currency depreciation. But opponents of a rate hike may be guilty of confusing the impact of interest rate levels and a change in rates. Even though the UK economy has lost momentum over the course of this year it is still growing at a rate of around 1.5% in real terms. Inflation, at 3%, is right at the top end of the threshold above which the BoE Governor has to write to the Chancellor explaining what he intends to do in order to bring it back towards target. Moreover, monetary policy is still operating on a setting designed to promote recovery in the wake of the 2008 financial collapse, with an additional bit of Brexit insurance thrown in. The UK simply does not need rates at current levels.

Arguably, the BoE should have raised rates in 2014 or 2015 when growth was back at trend and house price inflation was running at double-digit rates. However, the global interest rate cycle was not then supportive of a unilateral move by the BoE, with the Fed not yet having commenced its rate hiking cycle and the ECB beginning a phase of more aggressive monetary easing. As it turned out, with UK inflation running close to zero during 2015 and H1 2016, the BoE would have run the risk of repeating the mistake of the Swedish Riksbank which began tightening in 2010 only to have to reverse course in the face of a collapse in inflation.

As for Brexit risks, the BoE has been clear all along that this represents an economic shock against which interest rates can only provide limited insulation. In any case, taking back the precautionary 25 bps rate cut implemented in summer 2016 makes sense in view of the fact that the worst case scenario did not materialise. But a wider point is that ultra-expansionary monetary policy can inflict just as much harm as an overly restrictive stance – perhaps in ways we do not yet fully understand. We do know that low interest rates have helped to propel equity markets to record highs and produced an unjustified tightening of credit spreads. To the extent that investors have become less discriminating about what they buy when they are simply chasing yield, low interest rates distort normal market behaviour. And as the Japanese experience has shown, a lax monetary stance is no guarantee of economic recovery.

Rising interest rates will hurt – mortgage payments, for example, will go up which is no fun at a time when real wages are falling. But as those professionals treating drug addicts will tell you, sometimes it is necessary to take a clear look at where we are, how we have got there and accept that a bit of cold turkey is necessary for the longer term good.