On 2 November, the Bank of England raised Bank rate from 0.25% to 0.5% – the first rise since July 2007. But was now the right time to raise interest rates? Seven of the nine-person Monetary Policy Committee voted to do so; two voted to keep Bank Rate at 0.25%.
Raising the rate, on first sight, may seem a surprising decision as growth remains sluggish. Indeed, the two MPC members who voted against the rise argued that wage growth was too weak to justify the rise. Also, inflation is likely to fall as the effects of the Brexit-vote-induced depreciation of sterling on prices feeds through the economy. In other words, prices are likely to settle at the new higher levels but will not carry on rising – at least not at the same rate.
So why did the other seven members vote to raise Bank Rate. There are three main arguments:
||Inflation, at 3%, is above the target of 2% and is likely to stay above the target if interest rates are not raised.
||There is little spare capacity in the economy, with low unemployment. There is no shortage of aggregate demand relative to output.
||With productivity growth being negligible and persistently below that before the financial crisis, aggregate demand, although growing slower than in the past, is growing excessively relative to the growth in aggregate supply.
As the Governor stated at the press conference:
In many respects, the decision today is straightforward: with inflation high, slack disappearing, and the economy growing at rates above its speed limit, inflation is unlikely to return to the 2% target without some increase in interest rates.
But, of course, the MPC’s forecasts may turn out to be incorrect. Many things are hard to predict. These include: the outcomes of the Brexit negotiations; consumer and business confidence and their effects on consumption and investment; levels of growth in other countries and their effects on UK exports; and the effects of the higher interest rates on saving and borrowing and hence on aggregate demand.
The Bank of England is well aware of these uncertainties. Although it plans two more rises in the coming months and then Bank Rate remaining at 1% for some time, this is based on its current assessment of the outlook for the economy. If circumstances change, the Bank will adjust the timing and total amount of future interest rate changes.
There are, however, dangers in the rise in interest rates. Household debt is at very high levels and, although the cost of servicing these debts is relatively low, even a rise in interest rates of just 0.25 percentage points can represent a large percentage increase. For example, a rise in a typical variable mortgage interest rate from 4.25% to 4.5% represents a 5.9% increase. Any resulting decline in consumer spending could dent business confidence and reduce investment.
Nevertheless, the Bank estimates that the effect of higher mortgage rates is likely to be small, given that some 60% of mortgages are at fixed rates. However, people need to refinance such rates every two or three years and may also worry about the rises to come promised by the Bank.
Bank of England deputy says interest rate rise means pain for households and more hikes could be in store Independent, Ben Chapman (3/11/17)
UK interest rates: Bank of England shrugs off Brexit nerves to launch first hike in over a decade Independent, Ben Chu (2/11/17)
Bank of England takes slow lane after first rate hike since Reuters, David Milliken, William Schomberg and Julian Satterthwaite (2/11/17)
First UK rate rise in a decade will be a slow burn Financial Times, Gemma Tetlow (2/11/17)
The Bank of England’s Rate Rise Could Spook Britain’s Economy Bloomberg, Fergal O’Brien and Brian Swint (3/11/17)
Bank of England hikes rates for the first time in a decade CNBC, Sam Meredith (2/11/17)
Interest rates rise in Britain for the first time in a decade The Economist (2/11/17)
Bank of England publications
Bank of England Inflation Report Press Conference, Opening Remarks Financial Times on YouTube, Mark Carney (2/11/17)
Bank of England Inflation Report Press Conference, Opening Remarks Bank of England, Mark Carney (2/11/17)
Inflation Report Press Conference (full) Bank of England on YouTube (2/11/17)
Inflation Report Bank of England (November 2017)
Monetary Policy Summary and minutes of the Monetary Policy Committee meeting ending on 1 November 2017 Bank of England (2/11/17)
- Why did the majority of MPC members feel that now was the right time to raise interest rates whereas a month ago was the wrong time?
- Why did the exchange rate fall when the announcement was made?
- How does a monetary policy of targeting the rate of inflation affect the balance between aggregate demand and aggregate supply?
- Can monetary policy affect potential output, or only actual output?
- If recent forecasts have downgraded productivity growth and hence long-term economic growth, does this support the argument for raising interest rates or does it suggest that monetary policy should be more expansionary?
- Why does the MPC effectively target inflation in the future (typically in 24 months’ time) rather than inflation today? Note that Mark Carney at the press conference said, “… it isn’t so much where inflation is now, but where it’s going that concerns us.”
- To what extent can the Bank of England’s monetary policy be described as ‘discretionary’?
In three interesting articles, linked below, the authors consider the state of economies since the financial crisis of 2007–8 and whether governments have the right tools to tackle future economic shocks.
There have been some successes over the past 10 years, in particular keeping inflation close to central bank targets despite considerable shocks (see the Vox article). Also unemployment has fallen in most countries and to very low levels in some, including the UK.
But economic growth has generally remained well below the levels prior to the financial crisis, with low productivity growth being the main culprit. Indeed, many people have seen no growth at all in their real incomes over the past 10 years, with low unemployment being bought at the cost of a growth in zero-hour contracts and work in the gig economy. And what economic growth we have seen has been largely the result of taking up slack through unprecedentedly loose monetary policy.
Fiscal policy, except in the period directly following the financial crisis, has generally been tight as governments have sought to reduce their deficits and slow down the growth in their debt.
But what will happen if economies once more slow? Or, worse still, what will happen if there is another global recession? Do countries have the policies to tackle the problem this time round?
Quantitative easing could be used again, but many economists believe that it will have more limited scope if confined to the purchase of assets in the secondary market. Also, there is little scope for reducing interest rates, which, despite some modest rises in the USA, remain at close to zero in most developed countries.
One possibility is a combination of monetary and fiscal policy, where new money is used to finance government expenditure on infrastructure, such as road and rail, broadband, green energy, hospitals and schools and colleges. This would avoid the need for governments to borrow on open markets as the spending would be financed by new government securities purchased directly by the central bank.
An objection to such ‘people’s quantitative easing‘, as it has been dubbed, is that it would effectively end the independence of central banks. This independence has been credited by many with giving central banks credibility in controlling inflation. Would inflationary expectations rise with people’s quantitative easing and, with it, actual inflation? A lot would depend on the extent to which this QE could still be conducted within a framework of targeting inflation and whether people’s expectations of inflation could be managed jointly by the government and central bank.
How should recessions be fought when interest rates are low? The Economist. Free exchange (21/10/17)
The economy is failing. We need to think radically about how to fix it The Guardian, Liam Byrne (25/10/17)
Elusive inflation and the Great Recession Vox, David Miles, Ugo Panizza, Ricardo Reis, Ángel Ubide (25/10/17)
Economics since the crisis Vox on YouTube. Charles Goodhart (11/10/17)
Is the system broken? Vox on YouTube, Anat Admati (12/10/17)
Signs of a crisis Vox on YouTube, Christian Thimann (19/10/17)
Policy stances since 2007 Vox on YouTube, Paul Krugman (29/10/17)
Did policymakers get it right? Vox on YouTube, Paul Krugman (4/10/17)
- Why, during the next recession, will the “zero lower bound” (ZLB) on interest rates almost certainly bite again?
- Why would the scope for QE, as conducted up to now, be more limited in the future if a recession were to occur?
- Why have central banks appeared to have been so successful in keeping inflation close to target despite negative and positive demand- and supply-side shocks?
- Why are the pressures on government expenditure likely to increase in the coming years?
- How would a temporary price-level target help to tackle a recession when the economy next bumps into the ZLB? What would limit its success?
- Is it appropriate for central banks to stick to an inflation target in times when there is an adverse supply-side shock resulting in cost-push inflation?
- Why might monetary policy conducted in a framework of inflation targeting tend to lessen the impact of a fiscal stimulus?
- What are the arguments for and against relaxing central bank independence and pursuing a co-ordinated fiscal and monetary policy?
- What are the arguments for and against using helicopter money to boost private expenditure during a future recession where interest rates are already near the ZLB?
- What are the arguments for and against using ‘people’s QE’?
The latest edition of the IMF’s Fiscal Monitor, ‘Tackling Inequality’ challenges conventional wisdom that policies to reduce inequality will also reduce economic growth.
While some inequality is inevitable in a market-based economic system, excessive inequality can erode social cohesion, lead to political polarization, and ultimately lower economic growth.
The IMF looks at three possible policy alternatives to reduce inequality without damaging economic growth
The first is a rise in personal income tax rates for top earners. Since top rates have been cut in most countries, with the OECD average falling from 62% to 35% over the past 30 years, the IMF maintains that there is considerable scope of raising top rates, with the optimum being around 44%. Evidence suggests that income tax elasticity is low at most countries’ current top rates, meaning that a rise in top income tax rates would only have a small disincentive effect on earnings.
An increased progressiveness of income tax should be backed by sufficient taxes on capital to prevent income being reclassified as capital. Different types of wealth tax, such as inheritance tax, could also be considered. Countries should also reduce the opportunities for tax evasion.
The second policy alternative is a universal basic income for all people. This could be achieved by various means, such as tax credits, child benefits and other cash benefits, or minimum wages plus benefits for the unemployed or non-employed.
The third is better access to health and education, both for their direct effect on reducing inequality and for improving productivity and hence people’s earning potential.
In all three cases, fiscal policy can help through a combination of taxes, benefits and public expenditure on social infrastructure and human capital.
But a major problem with using increased tax rates is international competition, especially with corporation tax rates. Countries are keen to attract international investment by having corporation tax rates lower than their rivals. But, of course, countries cannot all have a lower rate than each other. The attempt to do so simply leads to a general lowering of corporation tax rates (see chart in The Economist article) – to a race to the bottom. The Nash equilibrium rate of such a game is zero!
Raising Taxes on the Rich Won’t Necessarily Curb Growth, IMF Says Bloomberg, Ben Holland and Andrew Mayeda (11/10/17)
The Fiscal Monitor, Introduction IMF (October 2017)
Transcript of the Press Conference on the Release of the October 2017 Fiscal Monitor IMF (12/10/17)
Higher taxes can lower inequality without denting economic growth The Economist, Buttonwood (19/10/17)
Trump says the US has the highest corporate tax rate in the world. He’s wrong. Vox, Zeeshan Aleem (31/8/17)
Reducing inequality need not hurt growth Livemint, Ajit Ranade (18/10/17)
IMF: higher taxes for rich will cut inequality without hitting growth The Guardian, Larry Elliott and Heather Stewart (12/10/17)
IMF Fiscal Monitor
IMF Fiscal Monitor: Tackling Inequality – Landing Page IMF (October 2017)
Opening Remarks of Vitor Gaspar, Director of the Fiscal Affairs Department at a Press Conference Presenting the Fall 2017 Fiscal Monitor: Tackling Inequality IMF (11/10/17)
Fiscal Monitor, Tackling Inequality – Full Text IMF (October 2017)
- Referring to the October 2017 Fiscal Monitor, linked above, what arguments does the IMF use for suggesting that the optimal top rate of income tax is considerably higher than the current OECD average?
- What are the arguments for introducing a universal basic income? Should this depend on people’s circumstances, such as the number of their children, assets, such as savings or property, and housing costs?
- Find out the details of the UK government’s Universal Credit. Does this classify as a universal basic income?
- Why may governments reject the IMF’s policy recommendations to tackle inequality?
- In what sense can better access to health and education be seen as a means of reducing inequality? How is inequality being defined in this case?
- Find out what the UK Labour Party’s policy is on rates of income tax for top earners. Is this consistent with the IMF’s policy recommendations?
- What does the IMF report suggest about the shape of the Laffer curve?
- Explain what is meant by tax elasticity and how it relates to the Laffer curve?
We have reported frequently in our blogs about concerns over rising debt levels among UK households. We previously noted the concerns expressed in July 2014 by the Prudential Regulation Authority (PRA) that the growth in consumer credit (unsecured lending) was stretching the financial well-being of individuals with implications for the resilience of lenders’ credit portfolios. Now the Chief Executive of the Financial Conduct Authority (FCA), Andrew Bailey, in an interview to the BBC has identified the growing problem of debt among young people.
In his interview Mr Bailey stresses that the growth in debt amongst younger people is not ‘reckless borrowing’ and so not borne out of a lack of willpower or ‘present bias’ (see John’s blog Nudging mainstream economists). Rather, it is borrowing simply to meet basic living costs.
In his interview Mr Bailey goes on to identify generational shifts in patterns of wealth and debt. He notes:
There are particular concentrations [of debt] in society, and those concentrations are particularly exposed to some of the forms and practices of high cost debt which we are currently looking at very closely because there are things in there that we don’t like.
There has been a clear shift in the generational pattern of wealth and income, and that translates into a greater indebtedness at a younger age. That reflects lower levels of real income, lower levels of asset ownership. There are quite different generational experiences.
Mr Bailey goes on to echo concerns expressed back in July by the Prudential Regulation Authority in relation to the growth in consumer credit. The chart illustrates the scale of the accumulation of consumer credit (unsecured lending) across all individuals in the UK. In August 2017 the stock of unsecured debt rose to £203 billion, the highest level since December 2008 when the financial crisis was unfolding. (Click here to download a PowerPoint of the chart).
In concluding his BBC interview, Mr Bailey notes that credit should be available to younger people. Credit helps individuals to ‘smooth income’ and that this is something which is increasingly important with more people having erratic incomes as the gig-economy continues to grow. However, he notes that credit provision needs to be “sustainable”.
Financial regulator warns of growing debt among young people BBC News (16/10/17)
Young people are borrowing to cover basic living costs, warns City watchdog Guardian, Julia Kollewe (16/10/17)
Britain’s debt timebomb: FCA urges action over £200bn crisis Guardian, Phillip Inman and Jill Treanor (18/9/17)
FCA warning that young are borrowing to eat shames Britain Independent, James Moore (16/7/17)
Young people are ‘borrowing to cover basic living costs’ and increasing numbers are going bankrupt, warns financial watchdog Daily Mail, Kate Ferguson (6/10/17)
More and more young people are falling into debt – but it’s not their fault Metro, Alex Simpson (20/10/17)
Bankstats (Monetary and Financial Statistics) – Latest Tables Bank of England
Statistical Interactive Database Bank of England
- What does it mean if people are financially distressed?
- What do you think Mr Bailey means by ‘sustainable credit’?
- In what ways might levels of debt impact on the macroeconomy?
- How does credit help to smooth spending patterns? Why might this be more important with the growth in the gig-economy?
- What is meant by inter-generational fairness?
- Of what relevance are changing patterns in wealth and debt to inter-generational fairness? What factors might be driving these patterns?
- What sort of credit is unsecured credit? How does it differ from secured credit?
- Are there measures that policymakers can take to reduce the likelihood that flows of credit become too excessive?
In various blogs, we’ve looked at the UK’s low productivity growth, both relative to other countries and relative to the pre-1998 financial crisis (see, for example, The UK productivity puzzle and Productivity should we be optimistic?). Productivity is what drives long-term economic growth as it determines potential GDP. If long-term growth is seen as desirable, then a fall in productivity represents a serious economic problem.
Recent data suggest that the problem, if anything, is worse than previously thought and does not seem to be getting better. Productivity is now some 21% below what it would have been had productivity growth continued at the rate experienced in the years before the financial crisis (see second chart below).
In its latest productivity statistics, the ONS reports that labour productivity (in terms of output per hour worked) fell by 0.1% in the second quarter of 2017. This follows a fall of 0.5% in quarter 1. Over the whole year to 2017 Q2, productivity fell by 0.3%.
Most other major developed countries have much higher productivity than the UK. In 2016, Italy’s productivity was 9.9% higher than the UK’s; the USA’s was 27.9%, France’s was 28.7% and Germany’s was 34.5% higher. What is more, their productivity has grown faster (see chart).
But what of the future? The Office for Budget responsibility publishes forecasts for productivity growth, but has consistently overestimated it. After predicting several times in the past that UK productivity growth would rise towards its pre-financial crisis trend of around 2% per year, in its October 2017 Forecast evaluation Report it recognises that this was too optimisitic and revises downwards its forecasts for productivity growth for 2017 and beyond.
As the period of historically weak productivity growth lengthens, it seems less plausible to assume that potential and actual productivity growth will recover over the medium term to the extent assumed in our most recent forecasts. Over the past five years, growth in output per hour has averaged 0.2 per cent. This looks set to be a better guide to productivity growth in 2017 than our March forecast of 1.6 per cent.
Looking further ahead, it no longer seems central to assume that productivity growth will recover to the 1.8 per cent we assumed in March 2017 within five years.
But why has productivity growth not returned to pre-crisis levels? There are five possible explanations.
The first is that there has been labour hoarding. But with companies hiring more workers, this is unlikely still to be true for most employers.
The second is that very low interest rates have allowed some low-productivity companies to survive, which might otherwise have been driven out of business.
The third is a reluctance of banks to lend for investment. After the financial crisis this was driven by the need for them to repair their balance sheets. Today, it may simply be greater risk aversion than before the financial crisis, especially with the uncertainties surrounding Brexit.
The fourth is a fall in firms’ desire to invest. Although investment has recovered somewhat from the years directly following the financial crisis, it is still lower than might be expected in an economy that is no longer is recession. Indeed, there has been a much slower investment recovery than occurred after previous recessions.
The fifth is greater flexibility in the labour market, which has subdued wages and has allowed firms to respond to higher demand by taking on more relatively low-productivity workers rather than having to invest in human capital or technology.
Whatever the explanation, the solution is for more investment in both technology and in physical and human capital, whether by the private or the public sector. The question is how to stimulate such investment.
UK productivity lagging well behind G7 peers – ONS Financial Times, Katie Martin (6/10/17)
UK productivity sees further fall BBC News (6/10/17)
UK resigned to endless productivity gloom The Telegraph, Tim Wallace (10/10/17)
UK productivity estimates must be ‘significantly’ lowered, admits OBR The Guardian, Richard Partington and Phillip Inman (10/10/17)
UK productivity growth to remain sluggish, says OBR BBC News (10/10/17)
Official Treasury forecaster slashes UK productivity growth forecast, signalling hole in public finances for November Budget Independent, Ben Chu (10/10/17)
The Guardian view on Britain’s productive forces: they are not working The Guardian, Editorial (10/10/17)
Mind the productivity gap: the story behind sluggish earnings The Telegraph, Anna Isaac (26/10/17)
Data and statistical analysis
Labour productivity: April to June 2017 ONS Statistical Bulletin (6/10/17)
International comparisons of productivity ONS Dataset (6/10/17)
Forecast evaluation report OBR (October 2017)
- Explain the relationship between labour productivity and potential GDP.
- What is the relationship between actual growth in GDP and labour productivity?
- Why does the UK lag France and Germany more in output per hour than in output per worker, but the USA more in output per worker than in output per hour?
- Is there anything about the UK system of financing investment that results in lower investment than in other developed countries?
- Why are firms reluctant to invest?
- In what ways could public investment increase productivity?
- What measures would you recommend to encourage greater investment and why?
- How do expectations affect the growth in labour productivity?