The case for a UK rate hike

The Bank of England is widely expected to raise interest rates by 25 bps this week, taking them above 0.5% for the first time since March 2009. The markets seem convinced, pricing such an action with a probability around 90%. It would be a major surprise if the Bank were not to deliver, with the markets so apparently sure. Indeed, if the BoE had a problem with current market pricing it would almost certainly have said something before now to try and nudge expectations. The fact that it has not done so is a strong indication in favour of a policy tightening. (If a rate move is not forthcoming … well, that is another story and we will deal with it if it happens).

There are those who believe that raising rates is a mistake (or at the very least that there is no need to act now). Their argument is sound enough: Price inflation is slowing; wage inflation is not picking up as anticipated and there are sufficient headwinds from Brexit that caution is warranted. If we were talking about an economy in which rates were a little bit higher than those introduced when the economy was about to fall off a cliff in 2009 I would be a bit more receptive to that view. But we’re not! Whilst Bank Rate of 0.5% may have been appropriate for an economy which was expected to contract by more than 3% in real terms, it is hard to make the case that is still the right interest rate 9 years later for an economy expected to grow by 1.5%.

For quite some time, I have believed that the UK rate setting process has taken an overly short-term approach to monetary policy. By looking only at short-term issues (e.g. the latest inflation or growth data) policymakers have been able to defer the need for a policy tightening. But in so doing, they appear to have suffered from what we might term “horizon myopia” without taking account of the fact that all these short terms eventually add up to an extended time horizon.

My argument for raising rates is the same as it has been for the last 3-4 years: The current interest rate is too low for general economic conditions. Those who believe that nominal GDP growth should act as a benchmark for the policy rate – and I am semi-persuaded of the merits of such a policy – argue that UK interest rates have deviated from GDP to an unprecedented degree in recent years (see chart). By itself, that is not proof of anything but it is an indication of the extent to which financial rates of return are out of line with those in the real economy which is likely to lead to economic distortions.

Arguably, excessively low (or high) interest rates distort capital allocation decisions – for example, by propping up zombie firms (though I am not sure that is a problem in the UK right now). However, they do distort savings choices. If returns to saving are low, this is a strong argument in favour of spending rather than saving. This is, of course, precisely what policy was designed to achieve during the depths of the recession but is it really necessary almost a decade on? And as I have pointed out previously, the longer interest rates are held at emergency levels, the bigger the risks to future generations of pensioners whose pension pots will not grow as rapidly as they ought. Indeed as John Authers noted in the FT last week whilst low interest rates prevented an economic meltdown, “it grows ever clearer that risk has been moved, primarily to the pension system.”

In my view, this is another strong argument in favour of modestly tightening monetary policy. At this stage we are not talking about a dramatic stamp on the brakes, but allowing rates to edge upwards by (say) 50 bps per year for the next couple of years would take some of the heat out of the problem. Whether the BoE will be in a position to do that depends, of course, on the extent of any damage that Brexit inflicts on the UK economy.