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’?
On election to office in May 2015, the UK’s Conservative government set new fiscal targets. These were set out in an updated Charter for Budget Responsibility. As Box 12.3 in Essentials of Economics (7th edition) states:
The new fiscal mandate set a target for achieving a surplus on public-sector net borrowing by the end of 2019/20. More controversially, government should then target a surplus in each subsequent year unless real GDP growth falls below 1 per cent … Meanwhile, the revised supplementary target for public-sector debt was for the net debt-to-GDP ratio to fall each year from 2015/16 to 2019/20.
What is more, the Charter requires the government to set a cap on welfare spending over a five-year period. Such spending includes spending on pensions, tax credits, child benefit and unemployment benefit. In July 2015 the Chancellor set this cap at £115bn for 2016/17, a reduction of £12bn.
Whether or not such a tight fiscal target is desirable, the government has been missing the target. In November last year, the Chancellor had to backtrack on his plans to make substantial reductions in tax credits and as a result the welfare cap has been breached, as the following table from page 5 of the December 2015 House of Commons briefing paper shows.
Also, with the slowing of economic growth, the Chancellor has stated that he will miss the requirement for a fall in the net debt-to-GDP ratio unless further cuts in government spending are made, equivalent to 50p in every £100.
But, if the economy is slowing, is it right to cut government expenditure? In other words, should there be some discretion in fiscal policy to respond to economic circumstances? There are two issues here. The first is whether the resulting cut in aggregate demand will be detrimental to growth. The second is who will bear the cost of such cuts. Critics of the government claim that it will largely the poor who will lose if the cuts are made mainly from benefits.
The articles below examine the public finances, the difficulties George Osborne has been facing in sticking to his fiscal mandate and the options open to him.
Budget 2016: Osborne’s economic fitness regime BBC News, Andy Verity (14/3/16)
Budget 2016: George Osborne fuels speculation of nasty shocks The Guardian, Larry Elliott and Anushka Asthana (14/3/16)
Charter for Budget Responsibility: Summer Budget 2015 update HM Treasury (July 2015)
OBR publications, including ‘Economic and fiscal outlook’ and ‘Fiscal sustainability report’ Office for Budget Responsibility
- Outline the main points of the Charter for Budget Responsibility (CBR).
- What are the arguments for sticking to fiscal rules, such as those in the CBR?
- What are the arguments for using discretion to adjust fiscal policy as economic circumstances change?
- Compare the Conservative government’s fiscal mandate with the newly announced approach to fiscal policy of the Labour opposition?
- How does the Labour Party’s new approach differ from the Golden Rule followed by Gordon Brown as Chancellor in the Labour government from 1997 to 2007?
- What factors will determine whether or not the government will return to meeting the rules set out in the Charter for Budget Responsibility?
Should the object of monetary policy be simply one of keeping inflation within a target range? In a speech given on 9 October, the Governor of the Bank of England, Sir Mervyn King, questioned whether the interest-rate setting policy of the Monetary Policy Committee (MPC) has been too narrow.
He considered whether interest rates should have been higher before the financial crisis and crash of 2007–9. This could have helped to reduce the asset price bubble and discouraged people from taking out excessive loans.
But then there is the question of the exchange rate. Would higher interest rates have pushed the exchange rate even higher, with damaging effects on exports? Today the trade weighted exchange rate is some 20% lower than before the crash. The government hopes that this will encourage a growth in exports and help to fuel recovery in demand. But as Dr King said, “The strategy of reducing domestic spending and relying more on external demand is facing a real problem because not everyone can do it at the same time.”
Then there is the question of economic growth. Should a target rate of growth be part of the MPC’s target? Should the MPC adopt a form of Taylor rule which targets a weighted average of the inflation rate and the rate of economic growth?
Certainly monetary policy today in the UK and many other countries is very different from five years ago. With interest rates being close to zero, there is little scope for further reductions; after all, nominal rates cannot fall below zero, otherwise people would be paid for borrowing money! So the focus has shifted to the supply of money. Several attempts have been made to control the money supply through programmes of quantitative easing. Indeed many economists expect further rounds of quantitative easing in the coming months unless there is a substantial pick up in aggregate demand.
So what should be the targets of monetary policy? The following articles look at Dr King’s speech and at various alternatives to a simple inflation target.
Mervyn King says must face up to monetary policy’s limits’ Reuters, David Milliken and Sven Egenter (9/10/12)
Bank of England’s Mervyn King defends low interest rates pre-crisis The Telegraph, Emma Rowley (9/10/12)
Banks should have had a leverage cap before crash, says Mervyn King The Guardian, Heather Stewart and Phillip Inman (9/10/12)
King Says BOE Must Keep Targeting Inflation as Tool Revamp Looms Bloomberg, Scott Hamilton and Svenja O’Donnell (9/10/12)
After 20 years, time to change Merv’s medicine? Channel 4 News blogs, Faisal Silam (9/10/12)
King signals inflation not primary focus Financial Times, Norma Cohen and Sarah O’Connor (9/10/12)
Should Bank start the helicopter? BBC News, Stephanie Flanders (12/10/12)
Twenty years of inflation targeting Bank of England speeches, Mervyn King (9/10/12)
- What are the arguments for using monetary policy to target a particular rate of inflation?
- Would it ever be a good idea to adjust the targeted rate of inflation up or down and if so when and why?
- Explain how a Taylor rule would work and in what ways it is superior or inferior to pursuing a simple inflation target.
- Are attempts to control the money supply through quantitative easing (or tightening) consistent or inconsistent with pursuing an inflation target? Explain.
- What are the arguments for and against abandoning targeting in monetary policy and replacing it with discretionary policy that takes a number of different macroeconomic indicators into account?
This podcast is from MSN’s Slate magazine. It is an interview with David Wessel, author of the book In Fed We Trust: Ben Bernanke’s War on the Great Panic. The book and the podcast consider the recent history of the Federal Reserve Bank of America (the USA’s central bank) and its handling of the sub-prime crisis and the credit crunch.
In Fed We Trust: A podcast with author David Wessel MSN Slate (10/8/09)
- What actions were taken by the Fed as the credit crisis unfolded?
- According to David Wessel, what mistakes were made by the Fed in handling the credit crisis?
- How successful was the Fed in steering the economy through the credit crisis and subsequent recession?
- How is the role of the Fed likely to change in the future?